First American Scientific Corp. (fka FASC)

[Jagman]

Rule No. 4: Buy Damaged Stocks, Not Damaged Companies

By James J. Cramer
RealMoney.com Columnist
3/10/2005 7:47 AM EST

Editor's note: Jim Cramer's new book, Real Money: Sane Investing in an Insane World, will be released April 5. During the month of March, we will be running previews from the book on Cramer's "Twenty-Five Rules of Investing." For more about the new book and to preorder it, click here. Today, we present Cramer's fourth rule of investing.

Let's say Wall Street is holding a sale of solid merchandise that it has to move. And let's say you take that merchandise home only to find it doesn't work, has a hole in it or is missing a key part. If we were on Main Street, of course, it wouldn't matter. There are guarantees and warranties on Main Street galore. You can take anything back.

You can't return merchandise on Wall Street and get your money back. Nope, no way.

Which is why I always say:

You have to buy damaged stocks, not damaged companies.
Sometimes these buys are easy to discern. In 1998, when Cendant (CD:NYSE - commentary - research) was defrauded by the management of CU International through a series of bogus financials, the stock went from $36 to $12 in pretty much a straight line. Was that a one-day sale that should be bought? No, that was a damaged company. It took years for Cendant to work its way back into the hearts of investors. Some say it has never recovered.

But when Eastman Chemical (EMN:NYSE - commentary - research) announced a shortfall a couple of months ago because of a problem -- a fixable problem -- at one of its facilities, that 4-point dip was a classic panic sale, one that you had to buy. The stock subsequently moved up a quick 8 points when the division recovered in the next quarter.

Sometimes, the sales on Wall Street aren't as obvious. I got snookered last year thinking that the Nortel's (NT:NYSE - commentary - research) accounting problems were a simple sale of a damaged stock, with the company quite whole. In fact, the company was gravely damaged by an accounting fraud, and I still don't know if it will recover. (By the way, I very much think that Lucent (LU:NYSE - commentary - research) is a case of a damaged stock with a company that is in a long-term improvement mode, a view not shared by many. But I am willing to hold it on the belief that the turn will be more obvious after several quarters.)

But when Eastman Chemical (EMN:NYSE - commentary - research) announced a shortfall a couple of months ago because of a problem -- a fixable problem -- at one of its facilities, that 4-point dip was a classic panic sale, one that you had to buy. The stock subsequently moved up a quick 8 points when the division recovered in the next quarter.

Sometimes, the sales on Wall Street aren't as obvious. I got snookered last year thinking that Nortel's (NT:NYSE - commentary - research) accounting problems were a simple sale of a damaged stock, with the company quite whole. In fact, the company was gravely damaged by an accounting fraud, and I still don't know if it will recover. (By the way, I very much think that Lucent (LU:NYSE - commentary - research) is a case of a damaged stock with a company that is in a long-term improvement mode, a view not shared by many. But I am willing to hold it on the belief that the turn will be more obvious after several quarters.)

And sometimes the sale is so steep that it looks as if something's dreadfully wrong, when really the problem is something that over the longer term will go away. That's how I feel right now about Tibco Software (TIBX:Nasdaq - commentary - research), which just warned of an earnings shortfall. After that company reports its next quarter I think we will discover that there's nothing wrong at the company, just a stock that was in bad, jumpy hands.

How do we know if there is something wrong with the company instead of just the stock? I think that's too complicated a question. What I like to do is develop a list of stocks I like very much, and when Wall Street holds an en masse sale, as it did yesterday with the oils because of the reversal in ExxonMobil (XOM:NYSE - commentary - research), I like to step up to the plate. I particularly like to be ready when we have multiple selloffs in the stock market because of events unrelated to the stocks I want to buy, a major shortfall of an important bellwether stock, or perhaps some macro event that doesn't affect my micro-driven story.

Of course, sometimes you just have to deduce that the company's fortunes haven't really changed, and the fundamentals that triggered the selloff (either in the market or in the company) will be something that will reverse themselves shortly. But you never know. Which is, again, why I think that the rule from yesterday -- rule no. 3 -- must be obeyed. If you don't buy all the stock at once, and if you take your time, it is more likely that you won't be left holding a huge chunk of merchandise when more bad news comes around the corner.