Avoiding Multiple Contraction

On Wall Street, Cramer often says, growth might as well be crack. It's highly addictive, and investors aren't afraid to pay up for it. That's why companies on a seemingly meteoric trajectory fetch the highest multiple, because they often generate the best returns. But the slightest change in sentiment can shrink that multiple like George Costanza just leaving the pool, so investors need to know when to cash out. During today's Mad Money, Cramer told viewers how it's done.

Warning Sign?
Warning Sign?   

If you’re new to the game, a stock’s multiple, or price-to-earnings ratio, is just the price of the stock divided by the earnings. It shows you what the market’s willing to pay for a certain level of earnings per share. Multiple contraction means the market will start paying a lot less for the same amount of earnings.

Only certain types of stocks are truly vulnerable to a multiple contraction – those with a high-multiple. Any stock that trades at more than 30 times forward earnings estimates could suffer a contraction, Cramer said. Anything with a PE over 40 is almost begging for it. When the market takes a dip, identify the high-multiple stocks in your portfolio.

Here’s an example of how things usually play out: You’ll see evidence of a slowdown or the Fed will hike interest rates a bit too far like it did in May 2006, and a lot of stocks that had been working will stop working. In fact, they’ll start going down. But you won’t see a severe multiple correction until your stock reports earnings, which is what happened to Whole Foods at the end of July that year, when its same-store sales growth came in 0.1% below estimates. By then, the market had been ugly for months, and investors already were pessimistic about most high-multiple stocks. That report looped in Whole Foods with the rest. The stock dropped 10% overnight.

If you want to avoid taking serious losses, then beware of multiple contraction. If you see a slowdown, you see a rate-hike that the market doesn’t like, then you should probably sell your high-multiple stocks before they report earnings. Waiting could cost you.

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