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Cramer: Investors Need 'This' Kind of Stock

Monday, 6 Aug 2012 | 6:24 PM ET

In a market that's become increasingly volatile, "Mad Money" host Jim Cramer recommends investing in secular growth stocks. Unlike cyclical growth names, earnings for secular growth stocks aren't reliant on how the market is performing and will even continue to expand during a slowdown.

Investors analyze growth by considering expected future earnings per share, Cramer said. The basic valuation algebra is the share price, P, equals the earnings per share, E, times the multiple, M. The multiple, by the way, tells investors what they're willing to pay for the company's future earnings. The most important determinant of the price to earnings multiple, Cramer said, is the company's growth rate. He said investors will pay a bigger multiple for businesses with higher growth because the growth means they will get larger in the foreseen future.

A Guide to Owning Secular Growth Stocks
To build a portfolio that can work in every kind of market, you need a fast grower, says Mad Money host Jim Cramer.

In general, a secular growth stock can trade up to a multiple that's twice the long-term growth rate before it becomes too expensive. So if the company is growing its earnings per share at a 20 percent clip, its stock won't trade down to a multiple of less than one times its growth rate unless there's something wrong with its fundamentals.

If you own a growth stock, Cramer said, be sensitive to which direction the earnings estimates are going and at what pace. Stocks can soar to new high after new high, he noted, but only remain cheap so long as the analysts who cover them are raising their earnings per share estimates fast enough. When estimates have momentum, a stock could double in twelve months and the multiple would be lower than where it started because the earnings estimates increased even faster than the share price. That momentum allows the stock to resist the downward pull of an ugly economy, Cramer said. If the multiple compresses, he recommends selling instead of riding the stock down.

"To build a portfolio that can work in every kind of market, you need a fast grower," Cramer said. "And remember when you're dealing with growth, it's worth it to pay up for a company that's still accelerating, because once a momentum stock starts to slow down, the multiple can shrink for ages before it bottoms."

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