Mad Money

Perils of bargain shopping

One of Jim Cramer's favorite things to do is sweep the market during a selloff and look for stocks that may have fallen too far, too fast. The strategy can generate significant profits.

However, just because a selloff drives a stock lower, that doesn't necessarily make it a 'buy.'

That may seem obvious, but the phenomenon can become quickly confusing if a selloff pulls a stock down to a level where it trades at a lower multiple than either peers or the broad market.

Michele Constantini | PhotoAlto | Getty Images

But make no mistake, "Just because a stock is cheaper than the rest of its cohort, it isn't necessarily a bargain," Cramer insisted.

The "Mad Money" host learned this valuable lesson first hand.

In the past, Cramer had owned Cisco in part because, "Cisco had a higher growth rate than the average stock in the S&P 500, but it sold at a lower price-to-earnings multiple than the average stock. "In short, Cisco looked cheaper than the market on both a pure earnings basis and a growth basis."

However, there was something Cramer didn't know. Even though the growth rate was higher than the average stock, "Cisco's growth rate was slowing," Cramer said.

In other words, the relative discount didn't matter. It was cheap but it wasn't a bargain.

"The company reported a shortfall soon after, and the stock got hammered, leaving the charitable trust holding the bag," Cramer said.

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"So here's the bottom line: yes, you should always be on the lookout for bargains, but just because a stock is cheaper than its peers or the whole market on a relative basis doesn't mean it's necessarily worth buying. Often inexpensive stocks are inexpensive for a reason, and if you buy something merely because its cheap, it may simply end up getting even cheaper."

The preceding insights are discussed in far greater detail in Jim Cramer's new book Get Rich Carefully.

Call Cramer: 1-800-743-CNBC

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