For more than 30 years, Jim Cramer has relied on a sophisticated method of stock picking.
Long before “Mad Money,” he managed a sizable hedge fund where his investment strategy allowed him to generate a 24 percent annual return after fees.
So, just how does Cramer pick stocks?
Cramer said he has far too many methods to divulge in one show, but revealed several of them on Friday’s program.
“I want to give you some of the tools of my trade, enough so that you can start to pick stocks like yours truly on your own,” Cramer said. “What I'd really like to do is empower you and that starts with me teaching you all the many tricks I use to pick out great stocks and trade them like a pro.”
If a Stock Hits a New High, Watch for a Pullback
Often times, Cramer finds stocks with upside potential by watching the new high list. There are only a few reasons why a stock might hit a new high, he explained. It could be part of a bull market, for example, or the underlying company may have “serious momentum.”
Either way, Cramer said many stocks on the new high list tend to push higher. That’s not an excuse to buy just any stock on the new high list, though. Instead, Cramer recommends waiting for a pullback.
(Related: 5 Stocks Set for Solid Earnings)
“The pullback gives you a good, lower priced entry point in a stock that's probably has a lot of positives going for it,” Cramer said, adding he doesn’t want investors to chase momentum. “You should always be conscious of price and therefore try to buy on weakness, just like you want to sell into strength.”
If a stock has pulled back from the new high list, Cramer only recommends buying if you are confident it can make a comeback for substantive reasons not having to do with the market. Sometimes stocks fall for good reason, so he reminds investors to know the difference between a broken stock and broken company. If the fundamentals haven’t changed, the stock probably fell for mechanical reasons, such as profit taking or panic in the overall market.
“While it isn’t a hard-and-fast rule, I tend to like stocks that have pulled back between 5 and 8 percent from the high. That’s the optimal level of a pullback,” Cramer said. “Less than that, you are probably too early. More than that and maybe something is indeed very wrong with the stock and you just don’t know it.”
As with any investment decision, though, Cramer said it’s important to do your homework and get as much information as possible about the underlying company and its stock.
Look for Insider Buying
If a stock hits its 52-week high and company insiders are buying shares, Cramer recommends investors follow suit. After all, an insider making the decision to buy the stock at the high instead of waiting for a pullback shows a great deal of confidence in the company and the ability of its stock to go higher.
“It's a rare thing to see happen, but in my experience, it's rarer still that this method of picking stocks doesn't work out,” Cramer said. “I love it when I see insiders buying at the high. It's a great sign of their confidence in the business and who knows the business better than the people running it, right?”
It’s important to make clear, though, that Cramer doesn’t think all insider buying is a bullish tell. Often times, company insiders buy a stock to create excitement. Insider buying at the high, however, is very rare and worth consideration.
When Insider Buying Meets Heavy Short Interest
Investors pessimistic about the future of a company’s stock can choose to engage in stock shorting, a tool that allows them to make money when a stock goes down. However, this strategy can be very risky.
Heavy short interest in a stock means a lot of people think the stock is likely to go lower. So if company insiders come in and start buying shares, it’s as if they are drawing a line in the sand to say the stock will fall no further.
“This is an explosive combination and one that often leads to a short squeeze that sends the stock much higher,” Cramer said. “Shorts are smart, but they usually don't know more about a business than the insiders who run it.”
So if a lot of people are shorting a stock, but then management starts buying sizable amounts of shares, Cramer thinks it’s time to do some homework because the stock will likely go higher.
Read on for Cramer's Top Dividend Stocks
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