The US government’s case against Galleon Management could be bad news for founder Raj Rajaratnam, who along with five other people was charged with $20 million worth of securities fraud and insider trading, but it offers valuable lessons for those who take the time to read through it.
Especially if they’re looking to explain the market’s confusing moves of late. Haven’t earnings been terrible compared with last year? If so, why did the Dow run another 96 points on Monday? Cramer used the nuggets of investing wisdom gleaned from the Galleon complaint to explain what’s going on. Here are five key rules that he found.
Hedge funds care more about guidance than earnings. In June 2007, the government alleges, Rajaratnam was in and out of Intel stock. At first, because a tip that the company’s earnings would come in better than expected and then later when another tipster predicted disappointing guidance. Sure enough, that’s just what happened, and INTC took a hit. How does that apply today?
“All last week we got great guidance,” Cramer said, “and the market went higher even though the earnings weren’t so hot.”
Focus on the top line and backlog, not earnings, when high-growth companies report. According to the Justice Department and the Securities and Exchange Commission, Rajaratnam went all in on Polycom before the stock took off, though not as a result of increased profits. In fact, it was the surprise revenues and backlog that catalyzed the move. Cramer said that these metrics were “the best way to judge [a] business” like Polycom.
Cost cuts matter. Let’s return to Intel to explain this point. After the stock plummeted as a result of that lowered guidance, Rajaratnam allegedly piled back in when news of a soon-to-be-announced cost-reduction program reached him through the grapevine. You can guess what happened next: The announcement sent the stock flying. What’s the takeaway here? A company restructuring can excite investors, Cramer said, as it did for Intel then and it’s doing for Caterpillar and Ford now.
The ultimate short defined: Missed earnings and sales, in addition to the drastically reduced guidance of both. The government says that Rajaratnam was told to short Akamai Technologies in anticipation of lowered guidance after reporting its quarter. The stock ended up falling 20% overnight when Akamai not only missed analysts’ sales expectations, but also forecast lower sales and earnings going forward, even lower than Wall Street had predicted. These kinds of stocks are “a total danger zone,” Cramer said, “even if the future’s bright for the industry.”
Linked quarters also matter. Another DOJ/SEC allegation is that Rajaratnam knew ahead of time that in the summer of 2007 Google would deliver a profit that was 25 cents a share lower than the previous quarter. That may not seem like much when a company’s earning $13 a share, but traders watch this quarter-to-quarter performance, called linked quarters, even more so than year-over-year. When Google reported as expected, the stock dropped $28, and Rajaratnam – again, allegedly – made almost $10 million. This kind of action could be seen today in Eaton, which reported miserable year-over-year numbers but great linked-quarter gains. ETN climbed $4 as a result.
In the end, Cramer said, the government complaint offers “fantastic insight into how the market really works and how hedge funds really make a killing playing earnings season.” Too bad, though, the feds make such a great case that “the market is often rigged against you.”
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