What's in the stock? What's not in the company?
That's how I like to view the two-pronged process of determining what to pay for a stock.
If you want to pick stocks you have to have a view of what a company can do in any business cycle.
Let's take two stocks: Nvidia (NVDA) , which sells at 50 times earnings, or a p/e of 50, and Nucor (NUE) which sells at 6 times, or a p/e of 6.
At first glance Nvidia is wildly expensive versus Nucor. But when you look deeper, maybe not. Nucor's stock just jumped about 40% from earlier in the summer. There's a lot of good news in the stock.
Nvidia's been consistent. I would like to think there is never enough good news in the stock, but that's a little gutsy. It just does so well no matter what the circumstances I often want to take the "what's in the stock off the table."
But now more important, what's in the company. When you see Nvidia selling at 50 times earnings what that usually means is that when we look back at how it did we will discover that it wasn't at 50 times earnings, it just turned out that the quarters were so much better that the stock turned out to be much CHEAPER than you thought.
Nucor? Just the opposite. It's at six times earnings, but that low multiple usually means that the earnings are going to fall off a cliff and it will look very expensive, maybe 20 times earnings or worse. If it weren't such a good company then it would be or worse for certain as you would expect from the highly levered Cleveland-Cliffs (CLF) .
Now there are all sorts of judgments you can make using this kind of thinking. The banks all have low multiples but they can be very deceptive. I know many think that the stock of Morgan Stanley (MS) which has been exceptional and up 51% with a 14 p/e has gotten ahead of itself. I look at things quite differently. I think that it no longer is a traditional bank. It's more of a wealth adviser for all sorts of demographics. That's a better business than a bank.
Goldman Sachs (GS) , however, even after its remarkable run, up 55% for the year, sells at just 7 times earnings. That's like Nucor; a belief that the earnings just won't be there next year and this year's numbers are just unlikely to be replicated.
Or how about construction. Deere (DE) is at 38 times earnings but Caterpillar (CAT) is at 21 times earnings. I would rather have Deere because its got infrastructure, but, more important ag, which, with these new food stamps and high grain prices looks very good. Cat's got mining - which is very strong and infrastructure, which is good, too. But that last quarter simply wasn't up to snuff.
What you are trying to do when you do this exercise is figure out what to avoid because it looks cheap but will turn out to be expensive - as say Micron (MU) is turning out to be - or looks expensive but turns out is a real bargain.
Think about that before you buy or sell anything. You don't want to throw away a perfectly good stock because its p/e is high. I would be more worried if its p/e is low. That's how perfect the market is usually. It's the imperfections that make the best investments.
(NVDA, NUE, and MS are holdings in Jim Cramer's Action Alerts PLUS member club. Want to be alerted before Jim Cramer buys or sells these stocks? Learn more now.)
