Cramer's Mad Money - Putting Earnings In Perspective (8/3/12)

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Includes: AGN, CMG, DG, DLTR, EOG, MCD
by: Miriam Metzinger

Stocks discussed on the in-depth session of Jim Cramer's Mad Money TV Program, Friday August 3.

P/E Ratio versus PEG Ratio

It is important to look beyond earnings when reading or listening to a conference call, because earnings can be propped up by stock buybacks and factors that do not indicate past performance or predict future success. Revenues are a better gauge than mere earnings, especially accelerated revenue growth, quarter to quarter and year over year. The PEG ratio puts earnings into perspective by measuring earnings per share by the company's growth rate. As a rule of thumb, Cramer only looks further into a stock that has a multiple no greater than twice the growth rate and a PEG ratio at 2 or less.

Cramer took some calls:

To research a company, the first step is to look at the company's website and pay extra attention to the annual report. Then, look at the news, take into consideration what analysts are saying about the stock, and only then consider whether it is worth buying or not.

Cramer explained that a reverse stock split is illusory. Investors get higher share prices, but fewer shares.

The ETF Effect. Stocks Mentioned: Dollar Tree (NASDAQ:DLTR), Dollar General (NYSE:DG)

Historically, about 50% of a stock's value was based on what sector it was in, but with the proliferation of ETFs, the sector can actually trump an individual company's earnings. If a whole cohort is out of favor, as the banks were in 2011, it hardly matters how an individual bank performs, or how much or how little exposure it has to Europe. Sometimes, individual stocks can trump the gravitational pull of the sector. While retail seemed to be in the doldrums, dollar stores like Dollar Tree (DLTR) and Dollar General (DG) were performing well. One strategy to deal with the conflict between individual companies' performances and sector popularity is to sell the ETF of a certain sector and buy only those stocks that are performing well in the sector, so if the cohort bounces back, the investor at least has some exposure to the sector.

Sometimes it is not enough to look at a sector, but one has to look at sub-sectors. This is essential, especially in tech, which is actually a combination of a host of sectors. Sometimes, cloud, for instance, might be performing well, but chips are not the place to be. In that case, investors should look at individual stocks in winning sub-sectors, rather than thinking of tech as a single sector.

About Gross Margins. Stocks Mentioned: Chipotle Mexican Grill (NYSE:CMG), McDonald's (NYSE:MCD), EOG Resources (NYSE:EOG)

Gross margins are an important indicator analysts use to indicate the long-term growth of a stock. Gross margins are what is left after costs are subtracted from sales. These costs vary from industry to industry, so investors need to know what they are looking for. What drives Chipotle Mexican Grill's (CMG) gross margins is customer traffic vs. input costs. CMG, until recently, has been able to offset higher commodity prices through its increasing customer traffic. Retail plays that emphasize strategies to instill employee loyalty and incentives also can keep their gross margins low, because rapid employee turnover exhausts a company's budget with demands for training and productivity. McDonald's (MCD) performs well with its gross margins by keeping its costs low.

The factor that can hurt gross margins in many industries, such as copper, steel, aluminum and semiconductors, is inventory. These companies often have problems with overproduction, which can cause a glut and require them to reduce prices. Pharma companies facing a patent cliff will have to reduce the price of their drugs drastically to face the oncoming competition, and this also reduces the gross margins. The main factors to look for in oil production companies is the costs of production versus the price of the commodity. EOG Resources (EOG) benefits from cheap finding costs and the current high price of oil.

Cramer took some calls:

While the 4th quarter tends to be crucial for many retailers, because of the holiday season, the first quarter hardly matters; "I don't care about the first quarter for retail," Cramer said.

An investor who shorts a stock can cover the short at any time. The difficulty is when the stock shoots up and the investor shorting the stock has to pay more to cover it. That is the essence of a short squeeze.

Dividends and Catalysts. Stock Mentioned: Allergan (NYSE:AGN)

There was a time when dividends were only an afterthought, and companies emphasized their buyback capabilities. Buybacks tend to do departing shareholders the favor of a higher selling price, but penalize long-term shareholders. Only a handful of buybacks do what they are supposed to do, namely, to return value to shareholders, whereas the vast majority are for short-term purposes, like propping up the share price. Dividend stocks are becoming more popular, and reinvested dividends are responsible for up to 40% of gains in some of the averages over the last ten years. On conference calls, it is useful to pay attention to how much cash the company has available to raise the dividend, and if it has a history of increasing the yield.

The other important thing to look for is a catalyst for a stock. A pharma company that has a drug in Phase 3 trials or an oil and gas company announcing a new prospect are examples of stocks with catalysts. Allergan (AGN) has been successful at discussing and looking for catalysts for its products, including multi-uses for its treatments. Allergan tends to bounce back even if it falls after earnings, because of the positive news it consistently discusses on its conference call.

International Exposure

Recently, macro news from overseas has trumped earnings. It is important to consider how much and what kind of international exposure a company has. From worries of Middle East conflict to ongoing angst over sovereign debt, these issues often effect movements of individual stocks or entire sectors. While China exposure not to long ago was considered a boon for a stock, it is just as often seen recently as a liability, given talk of a Chinese slowdown. Such exposure can explain a sudden drop in a stock, often caused by a downgrade or a headline.

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