Don't Forget To Do Your Homework

Cramer’s got a pick that he thinks no one buy, no matter how exciting his recommendation sounds, until the proper homework is done. This stock, Downey Financial , is fantastic, Cramer says, but what’s even better is how he found it – all that homework he’s always telling you to do but you never really do even though it’s crucial to the process of trying to make mad money.

So here are the long and arduous steps Cramer took to come up with DSL. Once again, he is not permitting anyone to buy this stock until they do their own homework.

It started with Cramer seeing that Wachovia reported a better-than-expected quarter that shocked a lot of the people who were betting against it. Wachovia bought a major California savings and loan company last year called Golden West, and the bears bet against it, figuring that Golden West would just bring a bunch of mortgage loss baggage with it, which would tarnish Wachovia’s bottom line.

But the integration of Golden West actually helped out Wachovia big time, and the short-sellers realized too late that they made a bad bet against the bank. But the Wachovia trade is over – you probably missed it but that doesn’t mean it’s irrelevant. Turns out, S&Ls from California are doing much better than expected, and Downey Financial is one of them.

Downey fits the pattern laid out by Golden West. It has 172 branches in California and Arizona, and one analyst at Lehman is calling the company “severely undervalued.” Cramer thinks that’s an understatement considering this company is trading at a mere 1.3 times book value. He’d call Downey feloniously undervalued, but he doesn’t want to offend the great Thelonious Monk.

There’s more than one way to win with Downey, Cramer says. Like Golden West, DSL could be a takeover target – the stock goes from $66 to $110 on a takeover, Cramer thinks, which could come from Wachovia or anyone else who wants some more exposure in California. That number didn’t come out of nowhere, and this where the homework really comes in. Remember, DSL sells at 1.3 times book value. Wachovia paid 2.8 times book for Golden West and if they paid just 2.2 times book for DSL – which would be about the going rate for these companies – that takes it to $110 per share.

If there’s no takeover, DSL isn’t a lost cause. The shorts have been flocking around the company like vultures, Cramer says, because they haven’t done their homework. They think it’s a prime candidate to blow up. It’s been linked to some of the worst names of the subprime lenders, but it’s got a positive credit outlook, a big, stable deposit base and most of its borrowers have premium FICO scores and plenty of equity in their homes, Cramer says. Forty percent of the float is short and just today DSL proved the shorts wrong – the big spike in defaults they were hoping for didn’t come true. Only 6% of the company’s loans are in subprime and at some point the shorts will have to cover their positions and buy stock. With 40% of the float sold short, that’s a ton of buying and Cramer thinks it could take DSL higher.

That kind of homework is how Cramer came up with Downey. He’s urging you to follow his lead before you buy it, or any company for that matter – and do your own homework. In this case, read the Wachovia conference call to try and get a feel for how Golden West worked and why you want something that looks like it, Cramer says. Look at some of the analyst research – Lehman and Keefe Bruyette both have buys on DSL and Cramer thinks both are worth listening to.

Bottom line: If you agree with Cramer – and if, and only if you do the required reading – you can buy DSL, a stock he thinks will go higher in several scenarios.

Questions? Comments?