Mad Money

Bottom-Feeding for Beginners

When Cramer talks about scales, he doesn’t mean music.

Scales are the method he used while running his hedge fund to buy stocks he thought were nearing their bottoms. As the share price dropped, he’d increase his position using wide scales.

Methods to the Madness

It’s easier to start by explaining strict scales first. A strict scale is when an investor buys a set amount of stock for each tick down in share price. If the price drops a point, the investor buys 1,000 shares, say. The amount of the drop and the number of shares bought are solely up to the investor. What makes strict scales strict is that the number of shares purchased stay the same for each tick down.

In widening scales, the number of shares Cramer would buy when running his fund would increase with each drop in price. First tick, 1,000 shares. Second tick, 1,500. When the price was as low as he thought it was going to go, he’d double his position. He recommends leaving some room at the bottom to snatch up much bigger positions in a favored stock.

The next logical question is, “How do I call the bottom?” Well, Cramer admits, that’s nearly impossible. But there are signs to watch for that tell investors that it might be close.

Once a stock has lost all its backing, the decline might almost be over, Cramer said. And when all the analysts that cover it have downgraded to “sell,” the end is almost certainly nigh. This is true because analysts base their ratings on earnings projections.

If a company beats projections, it’s a buy. If it consistently meets them, the stock’s a hold. If it misses even once, the stock gets a downgrade en masse. The thing to keep in mind is that just because a company misses one quarter – or even three quarters in a row – that’s no guarantee that it will miss the next time. So if a stock with solid fundamentals gets hit, it could be time to double down on that position you’re building, Cramer said.

Always be patient, though, Cramer suggests – it could take months for the stock to hit its genuine bottom.

Other quick signs of a potential bottom: when bad news or a negative rumor still doesn’t make the stock price sink, and if there’s significant insider buying after a huge decline (make sure it’s not a symbolic gesture to boost the stock price).

Bottom Line: You shouldn’t try to call bottoms in individual stocks. Instead, just use wide scales as the stock falls, buying in larger and larger increments as the price declines.

Questions? Comments?