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Cramer Explains This Critical Concept In Investing

Tuesday, 26 Apr 2011 | 7:09 PM ET
Cramer's Take on 'Risk-Reward'
Mad Money host Jim Cramer discusses one of the most important, and most poorly understood concepts for most people who manage their own money: risk-reward.

Risk-reward is one of the most important, yet most poorly understood concepts for people who manage their own money, Cramer said Tuesday.

To help home gamers better understand this idea, Cramer compared two stocks in the technology space and the data center space specifically. The data center has become an "area of explosive growth," as companies need to build out their network storage infrastructure to process increased amounts of data. Cramer looked at VMware , a high-flyer and the "hottest stock in the space." He also took a look at EMC , a slow growth name that owns 80 percent of VMware and has a great network storage business, as well.

"These are two great ways to play the data center," Cramer said of VMW and EMC. "They both reported fabulous quarters last week, but they are very, very different stocks."

VMware, for example, is the dominant provider of virtualization software that allows companies to run multiple virtual machines on a single server rather than having to buy multiple machines. Companies save an average of up to 70 percent thanks to VMware's products, Cramer said. He thinks it's a long-term, secular growth trend that's not likely to go away any time soon.

The stock is the definition of high-risk, high-reward, though, Cramer said. When there's good news, the stock soars and when there's bad news, it falls hard. VMware's stock can sometimes fall on disappointing news that's not even its own. If another data center stock reports a huge downside surprise, that might be enough to send VMW shares lower.

Cramer said not everyone has the stomach to own a roller-coaster stock, like VMware. That's OK. Investors have to decide what level of risk they are comfortable risk. For those terrified by great risk, he recommends staying away from VMware and considering EMC instead.

EMC is a play on the same trends as VMware, Cramer said. After all, the Hopkinton, Mass.-based company owns 80 percent of VMware. It accounts for just 17 percent of EMC's revenue, though. Its core business is information infrastructure, where its a leader in high-quality storage hardware for the data center. It has 26 percent marek share in that space, Cramer said.

Between the two companies, the big difference is that EMC is a slower, steadier growth company with a lower risk-reward stock, Cramer noted. EMC shares are much cheaper, too, selling at just 15 times forward earnings with a 15 percent long-term growth rate. VMware, on the other hand, grows at a 24 percent and sells for more than 48 times earnings. When VMware's stock got hit hard during the rotation out of momentum stocks in the first quarter, EMC's stock barely budged. It actually went up 4.4 percent while VMware's stock fell by 23 percent from mid-January to mid-March.

But EMC isn't going to rally as hard when business gets better. VMware's stock rallied more than 12 percent since it reported last week while EMC has only posted a 6 percent increase since its last quarter. Looking back to the generational bottom nearly two years ago, VMware boasts a 392 percent return while EMC is up 185 percent.

So which stock is better? Cramer said it's up to you. Home gamers can take a big chance with VMware or play it safe with EMC.

When this story was published, Cramer's charitable trust owned EMC.

Call Cramer: 1-800-743-CNBC

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