I’m pulling out my old hedge fund playbook to see which stocks are working — and which ones are not

How will we know if we are OK with the stocks we own? I want you to learn how to size up your companies by asking what they are levered to, what matters to them. This concept of levered is not about debt. It’s about figuring out what exposure these company have to key issues that can help assess if we are, indeed, OK. What will drive sales? Earnings? What could — can and has been — making things go right or wrong? I ran through this concept during the Investing Club’s June Monthly Meeting on Thursday. Why is it concept so important? It’s a quick way to sum up what’s ailing a stock or what’s really propelling it — all the better to know why you should hold on to something or cut bait. I found this levered concept incredibly valuable when I ran other peoples’ money at my hedge fund years ago. For example, brokers were always coming by my office back then to pitch new ideas. My first question to them, usually interjected, rudely, if I were bored or confused was: “What the heck is this business levered to?” Invariably, the broker touting the idea knew that I was really just trying to figure out if there was some overarching reason that could send a stock flying or sinking, and it would help me to be sure I was being diversified or that I wasn’t just betting on an earnings surprise. If they didn’t know what the company’s business was levered to, I usually told them to leave. If they knew what it was, but I wasn’t so sure things would pan out for the company, then I didn’t bite. But if they could present a story that demonstrated leverage to something that I thought was a legitimate driver, something I thought would definitely occur, then I would probably take them up on it. I traded a great deal back then, so I would be out of an idea immediately if things didn’t pan out. Palo Alto Networks To understand this kind of leverage that I am talking about — as opposed to the kind that involves debt —let’s start with something easy, let’s start with the stock of Palo Alto Networks . I know that it hasn’t done as well lately as CrowdStrike , but there is room for both, and I am beginning to believe that Palo Alto CEO Nikesh Arora has been winning some bigger business than I thought when he first came out with this idea of platformization, which involves bundling his products in a way that his customers can get better bang for their bucks. We own Palo Alto because its fortunes are levered to something that has the most explosive growth of an industry I know: cybercrime. As long as the bad guys seem to be able to strike at will, closing down whole companies, or even whole industries, as is the case with last week’s CDK Global auto dealer hack, and as long as no one ever seems to get caught or be imprisoned or even make restitution, then Palo Alto is going to be a stock you want to own. If we didn’t own Palo Alto we would own CrowdStrike. You have to have some business that is levered to a menace that strikes fear into the heart of every CEO. Even better, in Palo Alto’s case, it is often called in to help stop problems after a hack has been announced. Given that there is a four-day window between when you are hacked and when you have to tell the world you are hacked, it’s just an endless annuity stream for this company. Wynn, GE Healthcare, Danaher and Estee Lauder Remember I said figuring out what a business is levered to can help you stay diversified? We have four positions that certainly seemed to be diversified when we bought them: Wynn Resorts , a casino company; GE Healthcare , a maker of MRI machines in hospitals; Danaher , a maker of the best equipment for the life sciences industry, which is in tremendous growth mode; and Estee Lauder , a once ultra-blue chip cosmetics and skin care company. But I was looking at these four by sector, by industry, not by what they are levered to. All four are actually levered to the fortunes of China, both the companies and, more important, the stocks themselves. That means they are considered by many to be not ownable. Does it mean anything that Wynn is crushing it in Las Vegas? No. Or that its two Macao casinos are doing better than expected? No. The fact is that the Macao casinos are levered to the Chinese gamblers and therefore it’s too difficult to own or be bigger in no matter how much we like it. China’s too dicey for big money managers to take a swing at. Even as GE Healthcare and Danaher do the vast preponderance of their businesses away from China, roughly about 85% away from the world’s second-largest economy, that 15%, give or take a few percentage points, has colored their stories incredibly negatively. In this case, their stocks are more levered to China than their actual businesses. But who are we to tell others they are wrong to conflate the two? We keep hearing that the Chinese government wants to stimulate health-care equipment but the companies haven’t yet seen it. When we bought Estee Lauder, I was actually excited about how it was levered to China and was doing so well there. I knew at the time that China was only about a third of the business, but it was growing. Then Covid hit and the Chinese cut down on conspicuous consumption, and the Chinese consumer grew pessimistic — and even, it seems — world weary. I predicted none of this. So, we ended up owning a stock and a company levered to China with a CEO in Fabrizio Freda who then doubled down on China, hoping on a strong comeback to the world’s greatest cosmetics market. I got this wrong. They got it wrong. The leverage of both the stock and the company is such that, at this point, if anything good happened at all in China, we could see a rebound. But, candidly, you can see if you ask “what’s it levered to” someone might say: “China, but we already own GE Healthcare, Danaher and Wynn, so let’s cut our losses.” We didn’t. That was a mistake, a big one. It happens. You can’t stew. You have to move on. And we will. TJX and Costco TJX Companies and Costco , two of our huge winners, are levered to a frugal consumer. TJX, the off-price retailer behind T.J. Maxx, Marshalls, and HomeGoods, gives you unheard-of bargains because it pays cash for goods that other retailers are stuck with. Shopping there shows you are smart. People like being smart about not spending money these days. Costco drives a hard bargain with its suppliers in order to reward frugal club members. Neither TJX nor Costco is particularly endearing as places to shop. They are treasure hunt paradises, though, and that’s what matters to the American consumer who is still trying to make ends meet. This frugal consumer theme —whether they’re wealthy or not – is one I want to explore more. There are more ideas to mine here than I originally realized as you might have heard on “Mad Money” with Ollie’s Bargain Stores on Tuesday. Bottom line I ran through the rest of the portfolio using this levered concept during Thursday’s Monthly Meeting. You can watch the replay video for the rest. The important takeaway here is the power of knowing the stocks you own and putting them through this kind of stress test to make sure what you thought would work is, indeed, working. It will also help you recognize when things are not going your way in a position or positions so you can make an informed decision about next steps. (See here for a full list of the stocks in Jim Cramer’s Charitable Trust.) As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. Jim waits 45 minutes after sending a trade alert before buying or selling a stock in his charitable trust’s portfolio. If Jim has talked about a stock on CNBC TV, he waits 72 hours after issuing the trade alert before executing the trade. THE ABOVE INVESTING CLUB INFORMATION IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY , TOGETHER WITH OUR DISCLAIMER . NO FIDUCIARY OBLIGATION OR DUTY EXISTS, OR IS CREATED, BY VIRTUE OF YOUR RECEIPT OF ANY INFORMATION PROVIDED IN CONNECTION WITH THE INVESTING CLUB. NO SPECIFIC OUTCOME OR PROFIT IS GUARANTEED.

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