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Some Stock lnvesting Basics
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You now know how to buy stocks and how Wall Street and Main Street value merchandise. But what should you be buying and selling? What should you be owning? Should you own stocks at all? How many? For how much money? And for what purpose—for retirement, for fun, for college? How do you build your portfolio?

First, I hate one-size-fits-all answers to questions about you. We are all different, we all have different needs and different incomes, different worries and concerns. On radio, for example, I am always happy to answer questions on the relative worth of stocks, performing the exercise we just went through with the Maytag versus Whirlpool calculations. But those calculations don't help you if you don't have an investment strategy in the first place.

The most important reason why we invest, the most important reason why we will always invest, is that we don't make enough money in our day jobs to get us through the rest of life. We have to put money away, we have to save, because otherwise when we are done working and we don't have income coming in, we won't be able to afford life itself. But we also save because we know that if we can augment our in­comes we can have more fun, or give more money away, or buy things that we otherwise couldn't afford. We can save to help buy a house or a car or any other large-ticket item. And we also save to give to others in our family, for our children, and for the cost of schooling.

I mention all of these obvious needs because the methods I advocate for each are different. When we are saving for retirement, that's Job One, so to speak, and we can't screw it up. The standards are higher and the risks we take are lower than for any other task because we must have money once we stop working. The other lunds of sav­ings, because they simply augment current paychecks, don't require the conservative strategies that retirement money does.

We consider these two streams, the necessity stream (strictly for retirement) and the discretionary stream, as very different animals. Something that is right for the former could be extremely stupid for the latter. Complicating things further is the fact that we do different things and make different choices depending upon how old we are. When you are younger you can take far greater risks than when you are older because you have more time to make the money back from your paycheck. You also have more time to let the great cycle of stocks—in any twenty-year period high-quality stocks that pay dividends have outperformed all other asset classes—work for you.

Let's take the retirement stream first. It is vital that you start saving for retirement as early as possible. I had this drummed into my head, correctly, by my father, and to - give you the true sense of how important it is, let me tell you a story.

Because of some reversals in my life, notably that someone—never caught—stalked me while I was a reporter living in Los Angeles two years out of college, I had the misfortune to live in my car for much of 1978 and 1979. Even though I had barely enough money to eat and pay the Allstate liability bill—I waived the collision!—I still managed to put away $1,500 toward retirement. That's how important it is to start saving early, I put the money with Fidelity and the compounding of that $1,500 would be enough for most people to live on for several years of retirement. The logic of equities through thick and thin is that powerful.

I tell people that the younger you are the more important it is that you take even bigger speculative risks with that money because even if you get wiped out you have nearly your whole working life to make it back. That's why I favor the single most aggressive strategy available, accumulation of high-growth equities either through mutual funds or through your own selection—more on that later—until you are in your thirties, coupled with a percentage of assets devoted to speculation. When you get to the thirties, I llke to throttle back the risk level to stocks that pay dividends or have the prospect of paying dividends within the near future and cut back the speculation. In your forties, I like to introduce bonds into the mix. Bonds don't allow much growth of income; they are more a preservative of capital, a place to hold money with a little bit of return to be sure you have it for later. Depending upon when you need the money, I alter the equation. If you want to retire at sixty, I would put more than half of your retirement money in fixed income in your forties. If you intend to work for years after sixty, I would put much less in those placeholders. Your fifties begins the big shift toward more and more fixed income. And finally, in your sixties, unless, again, you keep working, fixed income should dominate. Your opportunities. to grow your money are now limited and the reward isn't worth the risk.

I mention the example of living in my car and saving for retire­ment because I am such a conservative when it comes to the later years. So many people call in to my radio show and say that they want to take more risks, that they want more aggressive investments because they didn't save early. Others in their sixties want my blessing to keep the vast majority of their assets in stocks. But I never bend on this. Here's why. I recognize the vulnerability of equities and the fallibility of my own judgment. Let's wind the tape back for a second to the spring of 2000. While I sensed that equities were overvalued, had I blessed a nontraditional, nonprudent course of action—staying in equities, particularly the kind of equities people were drawn to in that era—I could have wiped out people if they overstayed their equity exposure. You never know when it is going to be the spring of 2000 again, and you can't allow your judgment to be swayed by the chance to make more money in stocks than they might allow. The desire to let it grow over time, to let the dividend and income streams come your way, is what should drive retirement investing. Only as you get closer to needing the money should your caution take hold so that you don't let a lifetime's worth of savings be wiped out by a swift downturn in the market right before you need the money.

What I tell people, though, is that for the second stream, the discretionary stream, the money not cordoned off for retirement, the money meant to augment the paycheck for other needs, the stakes are much lower. Consequently, you can take bigger chances with this portion of your assets. With discretionary investments, risks predom­inate and rewards can be outsized. With this stream you can and must speculate with at least a portion of your money, perhaps as much as 50 percent when younger, in your twenties, and then dropping back by 10 percent every decade, but never falling below 10 percent, if only because that's what you can afford to lose without damaging your necessity money. It is with this money that you can take chances. It is with this money that you can and should be trying to make yourself rich with some excellent outsized risks that could give you giant returns. There you can take as much chance as you would like and I will most likely bless it, as long as you follow the rules I lay out in subsequent chapters. You can put this money in the riskiest of ventures, provided you are willing to do the homework first. There I want you to seek out small-cap speculations, provided you follow my rules of good speculation. There I want the steak, the fat, the stuff you love but the traditional financial books say will be bad for your financial diet. They are dead wrong. They are as wrong as all of those doctors that pooh-poohed the Atkins diet over the years. I need you to become fascinated with the market with some of those assets of yours, the more so when you are younger. The younger you are the more speculative you can be!

That people don't routinely look at these two streams as entirely different kinds of money, so to speak, with radically different rules, drives me crazy. The mistaken conflation of the two streams leads people to be far more risky in their retirement and way too conservative in their discretionary pool choices. So, if you learn one takeaway lesson from this chapter, it is the need to think and act very differently with these two rivers of potential wealth. People who want to specu­late in their retirement streams, particularly when they are older, will not get my blessing. People who don't speculate with their discretionary pool of capital are similarly making a huge mistake, provided they follow my rules on speculation. Mind you, this view is radical in its commonsense approach. Every other text I have read admonishes against speculation at all times. I think just the opposite. I want to build it in, provided you follow the rules of speculation, so that it is a tamed beast that can grow into something huge, then be stopped out before it can destroy your hard-earned capital.

Should you be running your 401(k)? Should you be managing your discretionary pool, or should.you hand it off to others?

The federal government, in fits and starts, has made saving for re­tirement a prhrity. It has created various confusing programs such as the IRA and 401(k), allowed us to take control of the non-Social Security portion of our savings, in a tax-deferred way. The tax-deferred nature of the programs makes them imperative. If you don't have an IRA or a 401 (k), by all means set one up this very minute to take advantage of the power of allowing your money to compound without your worrying how to pay the tax man. You must have a good menu of offerings to choose from and you shouldn't have to pay high fees to be in those investments.

It's terrific that we have been given control over some of our savings. But it is terrible that the government has given no instruction about how we should control it, no rules to follow, and no training about how to do it. We have all been made our own personal portfolio managers by the IRA1401 (k) revolution, but we haven't been given a dime's worth of education about how to be a portfolio manager. We teach kids in junior high and high school tons of things that are completely irrelevant, but we don't educate them one whit about how to take care of their own portfolios. It's flabbergasting to me to watch my kids read and learn about the Etruscans or about the hypotenuses and the order of the planets but nothing about stocks and bonds and portfolios! It drives me up a wall! Worse, the people whom the government wants us to rely on, the people in the financial services industries, have failed us mightily in instruction. In fact, I would argue that many of them have done their best to try to keep us in the dark, to make us less effective as clients or portfolio managers so we can be more reliant on them and they can make more money. I preach this every day when I say let me be your coach, let me show you how you can be your own portfolio manager, and if I can't do that, I know I can teach you to be a better client. You have to be one or the other, though, better client or better investor. There is no alternative. So let's see which one you are.

I like to build portfolios for both discretionary money and retirement money, with the former qnsisting of a diversified group of stocks as well as some speculation built in, and the latter being strictly common stocks when you are younger and then gradually moving to more fixed income as you go up in years.

What determines whether you are in shape to build a portfolio? When a caller asks me for help in managing or building a portfolio, I always tell her that I won't even help until she tells me if she has the time and inclination to manage money herself in a diversified fashion. I need to know both because not everyone can be a portfolio manager; some of us are always going to need the help of others who are professionals, either because we don't have the time to do the homework, or we lack the inclination to learn how to measure companies against one another to find the bargains that make for great investments. So let's explore these two great variables—time and inclination—in the context of building a diversified portfolio to see where you fit in.

When I speak of time, I am speaking of the time to do homework on your portfolio. I will detail what the homework entails later, but suffice it to say that I think the rigors of the market demand one hour per week per stock to stay on top of it. (I have found that to keep up with all of the pieces of information publicly available for each stock, you need that much time. It is a shorthand measure, but I have clocked it over and over again and it almost always turns out to be right no matter how known or unknown the company might be.)

When I speak of inclination, I mean the desire to do the work. I believe the rudiments are so easy—you have already performed the most difficult task in calculating the multiple—that I have confidence that if you have gotten this far into this book you have the smarts to doit.

It's the inclination that trips people up. I always say that you need the same amount of time to keep up on your stocks as to keep up on your local sports teams. The problem isn't the time; it is the desire to do the work. If you don't have that natural inclination, you won't spend the hour per "team" that you need to follow. So, you have to ask yourself whether you like this stuff enough to stay on top of it. (If you don't have the time or inclination, then you need help. I explain how to get help in a later chapter, so don't get disgusted or discouraged. There are many ways to skin the investment cat.)

Now, you might have the time and the inclination to spend a cou­ple of hours a week on your investments, which would be fine if you only had to own one or two stocks to get rich. But because of the third point, the need to diversify, you won't be able to spend just two hours a week on building your own portfolio. Diversification is the bedrock of portfolio management. Every Wednesday on Jim Cramer's Real- Money I play "Am I Diversified?" You dial 1-800-862-8686 and I ask you to give me your top five stocks. Then you ask, "Am I diversified?" I then play the "Hallelujah Chorus" or some funny jock jam if you are, or I give you the buzzer they use on Jeopardy if you aren't.

I play this simple game because diversification is the only free lunch in this whole gosh-darned business. Remember, owning stocks is a fallible process. You must never forget that these are pieces of paper. Pieces of paper can go down the drain as quickly as toilet paper if they are the wrong ones or we get into the wrong market.

That's why we have to diversify. When markets are going up, and when whole sectors are roaring, diversification seems like a huge drag. Why bother? When it is sunny, who the heck needs an umbrella or a raincoat? But when it is raining or stormy, or we get a hurricane like we had in the bear market of 2000-2003, diversification is your shelter, your virtual brick house that can't be brought down by the elements.

Diversification is also a weapon, a weapon against the malfeasance and the criminality that can engulf the investing process if we are not careful. You know how my game of "Am I Diversified?" came about? Do you know why I insist on playing it every Wednesday week in and week out? Remember the people who testified in front of Congress after the Enron debacle saying that their nest eggs were wiped out because they had kept all of their assets in Enron stock? They had all of their eggs in the Enron basket, in some cases millions of dollars in this one stock. The day that they testified, I happened to be talking on the radio about how badly I felt for these poor souls who had each lost hundreds of thousands and, in some cases, millions of dollars in Enron stock for their 401 (k)s and their IRAs. My wife, the Trading Goddess, happened-to be listening. She called in and let me have it. Just took me apart. She said how dare I feel bad for people who had millions of dollars and then gave it back in the market. How dare I feel bad for people who weren't smart enough to diversify and were so greedy as to not take the care to put their eggs in different baskets. I was just encouraging that kind of behavior for others when I could have been using their intellectual laziness and lack of knowledge about the value of diversification to drive home the point about how easily avoidable such heartbreak is. She was furious that I put the emphasis on the government's screwup in not catching Enron earlier. Diversification, she said, assumes that the government will screw up and not protect us. It presumes that companies' execs will at least let us down if not loot their own enterprises. When she was through with me, I said, Holy cow, I better appease the Trading Goddess and find a way to make diversification come alive on the show, pronto. So we now play "Am I Diversified?" every Wednesday, and while it may seem hokey, it works.

Diversification is not only our greatest defense against chicanery, it is also our lone defense against the fizzling out of whole companies and whole sectors. We can't afford to put too much money in any one area because that whole area could wipe out our wealth.

I know, this too seems counterintuitive. How could we not want all of our money in the hottest sectors? Why would anyone want to put money in places that aren't hot, that aren't working?

History, however, tells us how wrong that kind of thinking is. When I got in this business, I used to review portfolios that were made up entirely of oil and gas holdings because, well, it was 1982 and wasn't oil going to $100 a barrel? Those portfolios would have been wiped out by the decline in oil to $10 that happened soon afterward had I not diversified these portfolios to less "hot" areas. Similarly, in the mid-1980s, the hottest stocks by far were food stocks. The great consolidation of the food stocks was occurring at the exact same time that the entities were going global. General Foods, Kraft, and Pillsbury were soaring. These stocks were insulated from the tremendous Japanese incursionahat was occurring in manufacturing. Nobody wanted Mitsubishi ketchup; these food stocks were the lone safe spot as the Japanese wiped out much of our manufacturing base. I would see people whose portfolios looked like aisles two through seven in a Safeway or an Albertsons, for heaven's sake. That presumed that food was going to stay a growth business forever. Sure enough, by the 1990s, the food stocks had become stagnant. They have now underperformed for two decades, mooting the compounding process. They are barely investible because they have so little growth. You invest in them only for takeovers, and that's not a sound investment strategy. Those who have been betting on a Campbell or a Heinz takeover for the last decade or two have suffered horribly while other enterprises have generated both large capital gains and bountiful dividends.

Of course, for the last decade all anyone wanted was technology, but we are now seeing the drawbacks of a portfolio made entirely of four or five of the great tech stalwarts of the 1990s. Owning those stocks now is like watching paint peel! Those who flee from all tech to all pharmaceuticals might have their portfolios wiped out by drug importation from Canada . Each sector at one time or another faces potential extinction. So we spread our stocks among many baskets.

While this seems counterintuitive given how much we want to be in the sectors that are in favor, we understand the hazards of concen­tration all too well. Would we really accept a diet, for example, that consisted only of Porterhouse, T-bone, chuck, and sirloin? Would we like a diet made up of bread, cake, pasta, and oranges? Of course not. We know how unhealthy those would be. It's the same with stocks; we need a balanced diet of stocks at all times.

For many people, though, this diversification concept slips right through their fingers. People call me and say, "Jim, I own Cisco, Dell, Intel, Microsoft, and EMC—am I diversified?" When I ask them if they are serious, they try to tell me that they think they are diversified because they own a networker, a personal computer maker, a semiconductor company, a software company, and a storage company. Heck, those stocks are as interrelated as a kneebone, shinbone, ankle bone, and footbone, for heaven's sake. These stocks all trade together.

I know that on a day when- the NASDAQ, where a lot of tech lives, goes up 2 percent, you are going to feel like you are running with ankle weights if you own only one tech stock, but it is the two-ton weight on the downside we must fear, not the ankle weight when things are going well. And if you don't know the difference between these companies, if you don't know what they do for a living, then you don't have the time and inclination to do the homework necessary and you have to hand it off to a "professional." I put quotes around the word, though, because I can tell you that most "professionals" aren't much better about this stuff than you are. In fact, they amateurishly set up and run funds that claim to be diversified but are no more diversified than the mock tech portfolio I just described to you. They claim the defensive power of diversification, when, in actuality, they are faux-diversified, owning a ton of stocks that will trade as closely as if you had Super Glued them together. They know this flaw, but if they can shoot the lights out for a quarter or two, and they usually can, their marketing departments can make hay out of your money while the sun shines, and the portfolio managers are paid by the dollars they take in, not by what they make for you.

How many stocks does it take to be diversified? I have found that you have to have a minimum of five to capture true diversification and protection from the undesirable elements. It would be terrific to be able to have as many as ten positions to really ensure diversification, but then you will be bumping up against the time and inclination requirements that I have already detailed. More important, more than fifteen stocks and you have simply become your own mutual fund, something I hear about often in the portfolios people talk to me about on radio or send to me via TheStreet.com. If that's the case, if you in­sist on fifteen or more stocks, you might as well hand off your money to one of those mutual fund fellows, although the costs, in fees, will be prohibitive unless you select a passive model, such as an index fund, which doesn't allow the manager to trade at his own discretion and charges you a higher fee, often for nothing special at all!

For retirement, I don't want to include speculative stocks, but for the discretionary stream, one of the five choices should be speculative, and perhaps as many as two or three of the five can be speculative when you are in your twenties or early thirties and you can make back the money in the event your investment fails.

How Much Do You Need to Get Started?

Given that you need at least five stocks in the portfolio to take advantage of the free lunch of diversification, how can you build a diversified portfolio of stocks for, say, less than $2,500? That leaves each position with no more than $500 per stock, making it so you simply can't own enough of any good stock north of $10. That's no good. You run the risk of owning five highly speculative stocks in small dollar amounts, and that's not acceptable. The only way to get enough of each stock with that little money is to be in an index fund, an exchange- traded fund like a Spyder (a stock that represents the S&P 500), or a mutual fund. If that's all you do have, you would do best to skip to chapter 7, where I evaluate those offerings for you. Of course, you can still own stocks if you have less than $2,500, but you cannot be diversified, and I care too much about diversification to approve a portfolio of fewer than four high-quality stocks and one speculative investment. (When you get to that $2,500 mark one day, then you can call your own porfolio'stune.)

But if you have more than $2,500, you can easily build a diversified portfolio that can allow you to make excellent money over time. I believe that $500—five positions each for a total of $2,500—of virtually any stock is enough to start out with, provided you add to the positions over time with new money.

How do you build that portfolio? You need to find stocks that will go up faster and more consistently than other stocks. I will show you how to do the homework to find them and then how to do the homework to maintain them—remember it's buy and homework, not buy and hold, that matters. And you need to buy them right, through methods that I will also detail when I talk about how to accumulate stocks correctly and sell them right when they go wrong. Staying on top of your portfolio, pruning it correctly, selecting new positions— these are the fundaments of the process and I love teaching them. I promise you will learn to do it just as I do and that you will enjoy it as I do. So don't despair because you think right now you don't have the time and inclination. My methods, I believe, are so much fun and so compelling that maybe you will be willing to give up that one sports event or TV show or movie to focus on getting rich beyond your salary. Believe me, it is worth it like nothing else in the world.

What Is the "Homework"?

When I say we no longer believe in buy and hold, that we have adopted a new regime of buy and homework, what does the homework mean? People ask me this question more than any other when I tell them you need an hour a week per position that you maintain. What am I look­ing for? What do you need to see? What can be seen? Is the "homework" even possible, and does it assure success?

First, understand that ever since the passage of Regulation FD, a rule set up to benefit you—and to hurt the full-time professionals like I was—everything that can be seen, everything that can be known about a company without being an insider, is available to all. And, candidly, it is all you need to make the right decisions. You will never have all the information you need, but this public data will suffice.

When I first got into this business I had to spend a tremendous amount of time just trying to find current information about companies. I used to have to go to the midtown Manhattan library to read old microfiches of quarterly reports two quarters after they were filed.

But now everything's changed. Every quarterly report is instantly downloadable from the SEC's Web site for free. Almost every research firm makes its research readily available online, either on its own site or through Multex, which is owned by Reuters. So, the public documents and research are all right in front of you. No excuses.

I also used to have to get as many as twenty local papers a day to stay on top of the companies I owned. I would have to go through each business section every day to see if there was news about the cornpanies. Now Google or Yahoo! or Factiva make all articles everywhere instantly available for free, or for a small fee. You can go to the Web site of any local paper in America and get data on a company that otherwise was totally unavailable unless you subscribed to the hard copy of the newspaper. And this data is perhaps the single most important stream of data because good investing is often local investing. Local investing, or at least simulated local investing, that is, looking up what is said about your company in its local paper, gives you one of the best information edges you can have.

When I broke into the business, .worhng for wealthy families and small institutions, if you did enough commission business with me I might be able to get you to see a management presentation where you could get insights on companies nobody else would get. Those closed meetings are now illegal. Every meeting where anything of any materiality is discussed is webcast, again for free. You can't know some­thing I don't know. It's not allowed.

Further, I used to be able to call management teams and speak to high-level executives about how their business was doing, something you could never do. Now I can still make those calls, but management can't answer them. They will be fined or prosecuted for talking to anyone without talking to everyone. There is no offline insight that some have that is denied to others.

That's the good news. The bad news? You have to read every report, from the quarterlies to the annuals, you have to read every important article, you have to listen to all of the conference calls, and you have to read the analysts' reports. That's the basic homework you have to do. The calls can be up to an hour and a half in length, but they provide the best information possible. Listen to them before you buy, although I have almost never heard of an individual investor who listened to two or three conference calls before he bought. I would never own a stock unless I had listened first. This information is too vital.

I know that seems excessive. But you would do much more re­search if you were going to buy a car or a home, and yet, a stock is every bit as big an investment. All of this work can be done on the Web, so there really are no excuses.

What are you looking for? What will you learn on a conference call that you wouldn't learn otherwise? You are looking to see how a company is doing, you are trying to take the company's temperature. When companies report, you are looking for clues about how fast the company is growing as measured by sales or revenues (they are the same) or how profitable the company might be—that's the earnings per share. If your company is a young company, you are looking for fast revenue growth. If your company is older, it should have been able to figure out how to monetize that growing revenue into earnings, and then into dividends. Old-line companies should be trying to maximize the cash they take in (the cash flow) to reward shareholders. Some buy back stock, others pay dividends. Given the low tax rate on dividends now, it could be especially important to you to find stocks that do pay or can pay good dividends.

How can we tell if a company is doing better or about to grow earnings faster than we would have expected? The rate of revenue growth matters, but just as important is something called the "gross margin : ' or how much profitability each sale can generate. I know that this focus may seem a bit alien to you, but the simple way to look at it is to think about shopping at your supermarket. You know if you are buying a can of all-white albacore tuna for $1.40, and it cost the store $ 1.40 to buy the can it is selling, the store's taking a beating. If it is buying the can for $1.00 and selling it for $1.40, then it has a hefty profit margin. But if it then spends a lot of money on labor and plant and equipment and advertising to sell it to you, the business could still be a loser. And the store doesn't make it up in volume. A company has big margins when it can charge what it wants for what it makes. What determines that? Competition, cost of the items to make or procure, and the cost of doing business in general.

Some businesses are high-margin businesses because they have little competition. For example, Microsoft has little competition for Windows, save Apple Computer, so it makes a ton per Windows. In fact, it made so much that the government declared it a monopoly and tried to break it up. Intel makes a ton of money per microprocessor, almost 60 percent of the sale of each Pentium chip is profit. That's because, again, it has little competition. Utilities have no real competition, but not a lot of growth, either. Cable companies have natural monopolies, but those can be invaded by alternative methods of program delivery—satellite dishes—that can take down gross margins and destroy profitability. Some businesses, however, such as supermarkets, have tremendous competition and razor-thin margins. Other businesses, such as the basic materials businesses, can have hefty margins when their products are in short supply because there aren't enough plants making the products and then have terrible margins when the industries build too many factories. Still other businesses, such as drugs, have patent protection that gives them a hefty payout for seventeen years on new drugs but then, when the drugs go off patent, they are almost worthless to the companies. Some businesses have big profit margins only when the world's economies are booming. Those are "cyclical" concerns. Some businesses, such as farming, or road building, or military spending, or aircraft building, have big profit margins when their own business cycles catch fire. Others have profit margins regardless of the world's economies. These are called "secular" growth stories, independent of the cyclicality of economies. People will use Dove soap or drink Coca-Cola regardless of how strong or weak the economy is. People don't skip taking medicine when they are sick unless they can't afford medicine, and most developed societies won't let that happen. This secular-versus-cyclical decision, as we shall see, is at the heart of a great deal of good investing and can generate tremendous outperformance if you catch the right moment to shift or rotate between secular growth and cyclical booms.

Each business has what is known as a metric or a series of metrics that measure how it is doing versus its peers. For the cable industry, for example, the enterprise value per subscriber; for hotels, it is the av­erage revenue per room; for airlines, it is the average revenue per seat. In retail the measurement that gives you the best thermometer reading is the same-store sales, which compares how much business a store did last year versus this year. Restaurants are measured the same way. These metrics give a true measure of growth. Total revenues, on the other hand, could be augmented by new stores that are added to the mix. For technology, the metric is the gross margin per product sold. For financials, it is the net interest margin, or how much money was made on each dollar that the bank or insurance company or savings and loan had in assets.

If you are going to buy a stock in a business, you must find out what metric or metrics are important—always pretty self-evident from reading the research—so you know how your company measures up. If you don't understand the metric that an industry measures itself by, you haven't done enough homework to buy the stock. Go back and do the work until you do know. If you can't figure it out, you have not mastered the process enough to do it yourself, or you have chosen a stock from a group that is too hard to understand and you will not make the right move when the market goes against you, which it invariably will.

Remember, when you do the homework, you are trying to measure how the company is doing—how the company is doing versus its peers and how the company is doing versus all of the companies out there as measured by the S&P 500. While there are many components that can be measured, the main thing that your homework should identify is whether your company is growing faster than the average company. Once you can measure that—with information easily avail­able in the management's discussion and analysis section in the public documents or even on Yahoo! Finance, TheStreet.com, or a host of other sites—you have to compare it to the average growth of the S&P 500. Then, you have to compare its P/E multiple to the P/E multiple of the average company. A bargain is a company that is growing sales and earnings faster than the average S&P 500 company but sells for a lower multiple than the average. An expensive stock is one that sells at a PIE premium to the averages but grows slower. I would almost always turn my back on a company that has the latter, but be intrigued by one that has the former.

If everyone is doing the same calculations, you might ask, how can there be any bargains? Aren't stocks perfect indicators of the future, as the academics insist? And, you might be wondering, how can you be better at this stuff at home than I can be as a professional?

First, remember the market cares more about future growth than it does about past growth, and to anticipate future growth you need insight that not everyone has. (Don't worry, I will give you my tips for how I have spotted future growth ahead of others for years.)

Second, the market's constantly throwing sales that allow you momentarily to find merchandise that is growing faster than the average company for less 'cost than the other company. In other words, if you are patient, and if you can keep the bat on your shoulder and let the pitch come to you, you will be able to buy stocks more cheaply than you should, which is the essence of good money management, whether it be done by pros or by you. Waiting for a company's stock to go from expensive to cheap because the market is throwing a sale may be the smartest thing you can do when you are building your portfolio. Similarly, when the market takes one of your stocks from cheap to expensive, paring back your holdings is essential so you can pick up some more of the stock when it inevitably becomes cheaper again.

Of course, it would be simple if the only thing we cared about is growth of earnings and sales. But we also have to be sure that the en­terprise we are buying is financially sound. On my radio show I must refer to the balance sheet of the companies I talk about dozens of times per hour. I like companies with no debt and I don't like companies that have a lot of debt. When you have too much debt you can't pay the bills if your business runs into trouble. When you can't pay the bills, the creditors—the bond holders or the banks—take over the equity. It saddens me that so few people understand that if you just look at the "equity side n —the number of shares times the dollar price—you don't get the full enterprise picture. You must also consider the debt. A company like a Revlon or a Nortel or a Lucent looks incredibly cheap if you simply multiply the stock price times the shares. When you factor in the debt, though, it's not nearly as cheap as you think. That debt does matter. It can choke off the "healthy" business you think you are buying. Yet I must have gotten dozens of calls a week from people who owned the common stock of WorldCom or Kmart before they went bankrupt and thought they would be entitled to something. They didn't understand that they were holding a two of clubs against the bond holders' aces.

Don't be mystified by this stuff. It is easier than you think. If you are making $40,000 a year and you have payments of $40,000 a year in credit card debt and mortgages, you know you can't make it without having to file for bankruptcy. Same thing with companies. Companies present balance sheets every quarter that tell you whether they are tak­ing in more than they are paying out in interest or not. When the companies do their conference calls, they also post their balance sheets on the Web or make them available to you so you can make judgments just as I am suggesting.

Of course, some businesses take down a lot of debt as part of their regular enterprise. Merchants take down debt in the fourth quarter so they can have lots of goods to sell at Christmas. Airlines take down a lot of debt to buy planes. Cable companies borrow a lot of money to build out cable systems.

That's fine, as long as they are taking in enough money to pay back the debt. Given that I am an extremely conservative investor, I rarely own the stock of companies that borrow a lot of money. I like compa­nies without a lot of debt. The reason is self-evident: It is much harder to lose your money when you invest in companies that don't borrow money or are not extremely leveraged. When companies borrow money, either in the form of bank debt or a bond sale, the collateral is, well, you! Your shares. Your ownership shares. The bond bullies strip you of your ownership rights and take over the companies when things go bad. That's why you must be vigilant about doing the homework. You must be sure that you aren't investing in something that could be taken away by the bullies because they have the legal right in bankruptcy to do so. I know this seems very basic, but when things turned bad in the economy, I listened to caller after caller on my radio show who had no idea that their shares could be crushed, literally made to disappear, as the ownership of the company switched from the common-stock holders to the bond holders and the banks.

We don't study corporate finance in high school or college. We don't understand the capital structure of companies. But we do understand mortgages and credit card debt. I am sure, if you are a bank officer, that there will be situations where a heavily indebted individual, one without a good income, is a good risk for a mortgage or a Mastercard. But the odds are against it, so you most likely pass up the opportunity. Same with stocks. I am sure that my method, which favors companies without a lot of debt, is going to steer you clear of some incredibly good situations, real home runs that you will regret not owning as they go over the fence. But unless you accept that an indebted company is purely speculative and it takes up your speculative spot in a diversified portfolio, I will always tell you to say no to the investment. As I say all of the time on Jim Cramer's RealMoney, it takes only one really bad investment, one totally belly-up situation, to ruin your profits from all of the good stocks. And, believe me, as my old boss at Goldman Sachs, Richard Menschel, would remind me endlessly, there are no asterisks in this game. You can't say, "Well, I would have had a great year if it weren't for WorldCom," or "Without Enron, we would have made good money." Menschel drilled into my head the need to avoid the clunkers that can wreck all the good work of a diversified portfolio. Too much debt almost always crushes a company before it can make you enough money to merit the investment. Avoid the bad balance sheets, and most of the problems that befall investors will never visit you. Isn't that worth missing a one-in-ten shot that comes back from indebted hell?

In essence, the reasons you do homework are both offensive and defensive. The offensive portion is to identify companies that have the ability to grow earnings faster than the market thinks but are priced below what the market multiple is at the moment. You are trying to discover the unknown value of companies before others discover and exploit their value. You are also trying to identify whether everyone knows all that is good about your stocks and whether the company is more than fully valued versus others in the market. The defensive portion involves staying close enough to a company to see that it has fallen off the wagon and is beginning to take down more debt than it can afford. That, too, is readily obvious to those who do homework, but not to those who buy and hold. It is the latter situation that must be detected before It destroys all of the good elements of your portfo­lio. Remember, you have to play both defense and offense in order to turn small amounts of money into large amounts.

Before we leave the notion of homework, let me tell you what is not homework. Looking at the chart, the graphic demonstration of where a stock has gone, is not homework. It can tell you nothing. Some think it is the sole compilation of all investing thought and from it you can divine the next move. That's preposterous, and I have the tire tracks on my back to prove it, for I have been short, or have bet against, many a failed chart only to be hit by a huge takeover and a subsequent wipeout. In investing a picture is not worth a thousand words; in fact, it is worth almost nothing. A chart is never enough to buy a stock from. Never. Don't be conned into believing that looking at a chart can suffice for homework; it simply can't.

Similarly, the commodity "too1s" that brokerage houses try to por­tray as proprietary and therefore somehow generating an edge for you are meaningless in the real investing firmament. When you see a brokerage ad with people talking about how the "tools" are all there to pick stocks, you should run, not walk, to another broker. There are no "tools" that generate buys and sells, just hard work and research— which tools, if anything, will obscure. The reason why these brokerage houses advertise tools is that they don't provide any real research of any value but have to try to lure you in with some pretense of specialty.

Not to praise Wall Street research too much; as I have said many times, some of my biggest gains were made betting against Wall Street research. But the one thing that Wall Street does excellently is create primers about industries that allow you to help figure out the metrics. Before I ever buy a stock in a new industry I always do my best to locate the research primers from whatever houses have written them, whether it be nanotechnology or the clothing or restaurant industries. I need the benchmarks to make educated decisions. So do you. You can use Yahoo! Finance and TheStreet.com to find them.

Once you have decided to focus on a single stock for your portfolio—for either your retirement or discretionary account—you have to figure out mentally what's the risk-reward of that particular equity. You have to make a judgment about what the market will ultimately pay for a stock using the PIE parameters outlined earlier. Risk-reward analysis defines the short-term stock picking that profes­sionals do, and I want you to understand the motivating forces behind it. Assessing the risk is a question of assessing the downside. Assessing the reward is a question of assessing the upside. The upside and the downside are created by two different buying and selling cohorts that you must understand in order to figure out the analysis correctly. The value guys create the bottom; the growth guys create the top. Fortunately, because I am chameleonlike in nature and inherently unwilling to be anything but flexible, I understand both teams, the value team and the growth team, and I can tell you what constitutes wins and losses for each team. People are always calling my radio show and asking how I judge the risks and rewards of individual stocks. I tell them that I like to think about where the value guy will begin to buy a stock after the growth guy has given up on it, and when the growth guy will begin to sell the stock because the growth is slowing or no longer accelerating at an attractive enough level for the growth stock buyer.

I boil it down on my radio show to something quick and dirty: "Three up five down, or ten up, three down." That's because I like to know the upside and the downside before I buy so I know if I can handle the pain. But let's go through the exercise of how I judge the risk-reward in real life so you can do the same.

Recently a caller, Bob, asked me which I liked more, Rite Aid or Walgreens. He wanted my blessing to buy Rite Aid over Walgreens. I could tell that he would have vastly preferred me to recommend Rite Aid because, as is so often the case, it was simply more tempting because of its small dollar amount: Rite Aid was at $5.31 and Walgreens was roughly $30.

I told him I couldn't go there. I mentally calculated the upside and downside of both and concluded that Walgreens was the cheaper and less risky of the two and the better stock over the long term.

Here's how I did it. First, I took a look at the long-term growth rates of both companies, just as I taught you to look at Whirlpool ver­sus Maytag. Walgreens is growing earnings at 15 percent, Rite Aid is growing earnings at 12.5 percent. WAG'S growing faster than RAD. But when I calculated the price-to-earnings multiples of the two— remember that's how we figure out what's expensive and what's cheap, not by assessing the $5 that RAD trades at and the $30 that WAG trades at—I discovered that Rite Aid is trading at 40 times earnings while Walgreens is trading at 25 times earnings. Given that Walgreens earnings are growing 20 percent faster than Rite Aid's, it simply makes no sense to me—and will make no sense to the big money that controls the marginal prices of stocks—that you should be paying a huge 15-point multiple premium for Rite Aid. The upside, set by the growth buyers, won't allow Rite Aid to trade much higher. The growth buyers will, indeed, be willing to pay more than 25 times earnings for Walgreens' consistent growth, because we have seen multiples of up to 40 times earnings for long-term consistent growth, especially at a time when other companies are having a hard time growing. (That's the upper limit of what disciplined growth buyers are willing to pay. There is always someone willing to pay any price, and later on I will talk about how to game those folks, but right now we are trying to do traditional risk-reward.) Given that Walgreens is slated to earn roughly $1.30,I could see the stock trading at an upper limit of 40 times earnings, or $52 a share. That's a sharp 70 percent gain from $30 a share where the stock was when Bob called me.

Now let's consider the upside of Rite Aid. It is already trading at the ceiling of what good, disciplined growth players will pay, 40 times earnings, so I think the reward for the stock is roughly where it is selling now. It is more than fully valued by the growth guys already. No gain.

Once we have quantified the upside, as defined by the growth buy­ers, we have to consider the downside, where value buyers would step in to stem the decline. As I have often described, most market players care about growth, but there is a smaller, yet still very disciplined cohort that actually likes to buy stocks as proxies for the businesses underneath. These are called value buyers, and they are the potential trampolines, or at least safety nets, that will get under a stock after it disappoints and create a bottom betting that something good— takeover or turnaround—will happen to the company the stock represents, and to you if you simply buy the stock cheaply enough.

These buyers look at abstractions such as the book, or replacement value, of an enterprise, or what other companies have been willing to pay for similar entities in the same industry. Given that Walgreens is the largest drugstore company in the United States , it is unlikely that it can be taken over. So what the value buyers in a WAG would look for is a time when the stock is getting shelled, perhaps because of short- term considerations, like a missed monthly sales number or a weak Christmas, or a market sell-off in general, a time when they can get this fine grower for below its long-term growth rate. The way these folks think is, "Okay, Walgreens grows at 15 percent. If I can ever buy that stock at a PIE that is at a slight premium to that growth rate, instead of the excessive premium it sells for now, I could patiently wait until the growth-stock buyers realize what they are missing and they bid the stock up again."

Again, I expect Walgreens to earn $1.30 a share. Knowing that value guys start early and then buy as a stock goes down, I would expect the value buyers to show up at around 17 times earnings, or about $22 a share. That would put the downside of Walgreens at about $8 below the current price, which is a lot, but on a percentage basis, which is what matters, you are looking at around a 25 percent poten­tial decline before the cushion sets in.

When will the value buyers settle in to stop a decline in Rite Aid? I expect Rite Aid to earn 264. Value guys would step in when the multiple is, again, at a small premium to its 12.5 percent growth rate. Using the same haircut I gave Walgreens, that would mean roughly 14 times earnings, or $3.64.

Now, let's recap the risk-reward so far: I see Walgreens as having 22 up and 8 down, a fantastic risk-reward. I see Rite Aid as having nothing up and around a buck and a half down. That's not an acceptable risk-reward ratio versus Walgreens.

Wait, it gets worse. We have only looked at the equity side of the balance sheet. I then did the balance-sheet analysis of Walgreens versus Rite Aid, which is incredibly important to let you be sure the bond bullies won't one day be in charge. The key to balance-sheet analysis, as always, is to figure out what kind of interest the company has to pay each year on its equivalent of a mortgage it might have taken out. Sure enough, Rite Aid has to pay $330 million in interest. But it only has $284 million in operating income. That's not a sustainable situation.

So far everything's pretty quantifiable. But I also like to factor in what I know about some other variables, variables involving the industry and the management of the two companies. These also assess future growth and help flesh out the "exact" nature of those earnings estimates that I was using to calculate multiples. They are necessary additions to the process because they inject real world concerns into an otherwise sterile arithmetic competition.

I know, for example, that the drugstore business is already "over- stored," meaning that it is a mature industry. I know that because a quick search of the articles about the industry—a necessary part of anyone's homework—shows me that many of the players in the drug­store industry have nowhere to expand. Perhaps Walgreens can move into the food business or Rite Aid the dry-cleaning business, but that's not been in their skill set so far. I also know that JC Penney is selling Eckerd to CVS, which means that the competition is about to get even tougher because CVS is, like Walgreens, an excellent outfit. I can also see from the clips that Wal-Mart says it wants to enter the drugstore market, and we know that Wal-Mart laid waste to the supermarket business when.it chose to go in, so who knows what havoc the big chain can cause drugstores.

That could mean that the highly indebted player, Rite Aid, might not even be able to make it. Walgreens, with its clean balance sheet, is also known as a well-run, stable enterprise when it comes to management. There's been very little turnover during its most recent past. A quick look at Rite Aid, though, shows pretty consistent turnover— including some because of criminal prosecutions—again a real negative.

All these subjective and balance-sheet tests tell me that if anything, the $8 down/$22 up analysis I have done for Walgreens is probably conservative on the downside and the upside, whereas the downside of Rite Aid may be even greater than the buck and a half that I thought it might be, maybe as much as $2-3 more, given that no company will want to buy an indebted Rite Aid if it looks as though the company might have to declare bankruptcy because it can't pay its interest. Remember, in that situation the common stock gets wiped out, crushed. What you own will be gone.

So, it all gets translated like this: "Bob, the risk-reward of Wal- greens versus Rite Aid is simply so much better that you can't afford to risk buying Rite Aid. You may have a very compelling reward with Walgreens."

Could I be wrong? Of course, there are multiple factors that are involved in the process that I haven't taken into account. Maybe Walgreens is having a better than expected quarter right now and it could be worth even more. Maybe Rite Aid could attract a takeover bid simply because lots of companies do stupid things. Maybe Wal-Mart buys Rite Aid, even though that seems unlikely because WMT is known as a disciplined buyer, and paying north of $5 for RAD is undisciplined, to say the least. There are always unknowable facts in the investment process, always, but we can't let them undermine judgment to the point that judgments can't be made. Because then we might as well put the money in the bank. For the purposes of Bob's query, I am con­fident that I have offered him the best judgment that can be made. Notice, Bob has made up his mind to own shares in a drugstore chain. It is not my job to talk him out of such an industry. It is simply my job to portray the risk-reward as best I can.

When I make these calculations, I am doing so only against other members of the drugstore cohort. In real life, nothing exists in a vacuum. But I would be doing the same calculus for Rite Aid versus, say, the S&P 500.I used the S&P 500 as a benchmark, not just to figure out what the whole market is doing, but also to figure out what I should pay versus individual stocks. If Rite Aid is cheaper than the S&P 500 but growing faster than the S&P 500, then indeed it is a bargain. But if it is more expensive than the S&P 500 and is growing slower than the S&P 500, then it should be a sell, not a buy.

That's the basic daily decision-malung process on Wall Street. These risk-reward parameters will work for any stock and are excellent for comparing one stock to another. But how do you find out when stocks are about to embark on their runs? How do you find out, for example, if Walgreens is about to journey to $50 instead of languishing at $30? How do you find the trigger, the catalyst for such a move? And, more important, how do you find stocks that can defy traditional risk-reward parameters, situations where there could be, say, 100 points up and 10 down, or even 300 points up and 20 down? How do you find the 10Xers, the super growers, without putting too much capital at risk in the process?

How can you spot gains of all varieties, from the small 3- to 5-point gains that can be fabulously winning on an average annual return basis, to the 20-, 30-, and 50-point gains that might disappear soon after or might continue on indefinitely? That's the subject of our next chapter.

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