Mad Money

Cramer: Horrifying stocks to avoid in a sell-off

Jim Cramer always says that when there are huge losses on the market, investors have the opportunity to buy good companies with stocks that have taken a beating because of the market. His motto in a downturn is "buy broken stocks, not broken companies."

But in a market-wide correction where everything under the sun is sold off, how do you know the difference between a broken company that's not bouncing back and a broken stock?

That is exactly why Cramer recommended that when you are in the middle of a sell-off, the first thing to do is to look at the companies that caused it — they are probably broken.

"If you're looking at a company that is part of the reason for a correction, you're looking at a broken company. Those are directly in the blast zone and certain to be obliterated," the "Mad Money" host said.

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For instance, in 2007, there were multiple sell-offs related to a weak real estate market and tons of bad subprime and regular loans. Anything that touched housing, mortgages or any kind of lending would have been considered a broken company.

Another thing that Cramer thinks is important to keep in mind is that a company does not break just because its stock goes lower. Investors saw this in 2012 when domestic companies were brought down just because of turmoil in Europe. How could a Mexican restaurant chain like Chipotle take a hit because of Italian bonds? It happened.

Stocks like Chipotle went down because all stocks were going down at the time, not because it had a connection to the sell-off.

"To put it another way, you don't want to buy the stocks that are leading the decline when you're looking for opportunity in a sell-off. You want to look for stocks in areas that are independent of what's ailing the market," Cramer said.

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Once a company breaks, it is very difficult to put it back together again. The same goes for sectors, which control half of a stock's movement.

That is why it is important to keep an eye on the stocks that cause a sell-off. Some stocks will have a clear reason for going lower, and others will just be sold off with everything else. The first stocks to be sold will be the broken companies — which Cramer says to avoid at all costs — and the second group will be broken stocks. Those are the stocks you will want to gobble up.

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