Rule of 40, max position size, price targets — we explain these 3 investing concepts

You may have noticed our new weekly Mailbag education feature , where we answer subscribers’ questions as part of our commitment to demystifying Wall Street jargon and trading concepts to help make you a better and more informed investor. Here’s our Mailbag email: investingclubmailbag@cnbc.com — so you send your questions directly to Jim Cramer and his team of analysts. Make sure to read our weekly Mailbag dispatch to see if your question is one of the ones chosen. This week we tackle three questions from our members. Question 1: I really enjoy the learning that is shared to make me a better investor. Can you share again the rule of 40 and when to use it? Kind regards. — Diane A. The rule of 40 is a quick and easy way to determine if a company is appropriately balancing growth with profitability. If a company’s revenue growth rate and profit margin add up to 40 or greater, you have a winner. This signals that management is adequately balancing growth and profitability. If the sum is below 40, the trade-off between growth and profitability is insufficient and the stock should be avoided as management either isn’t delivering enough growth to justify the lack of profitability, or enough profits to justify the lack of growth. Revenue growth is pretty straightforward — you are simply using the annual revenue growth rate of the company, but profit margins can be open to interpretation. We like to use the EBITDA margin as our profit metric of choice. Some analysts and investors take an even more conservative approach and use the operating profit or EBIT margin, or free cash flow margin. (EBITDA stands for earnings before interest, taxes, depreciation and amortization.) A company could be growing at 50% with a minus 10% profit margin, or at 30% with 10% profit margin. As long as it adds up to 40%, the company is deemed worthy under this rule. Generally, this method is reserved for smaller, fast-growing companies that don’t have earnings, whereas more traditional valuation models based on earnings or EBITDA are used for profitable businesses. Still, investors can use the rule of 40 for any company where revenue growth is core to the investment thesis. Question 2: How do you determine how large a particular stock holding should be in the portfolio? Is there an absolute limit (such as 5%) that you place on any one stock in the portfolio? Thank you for all you do for us home gamers. — Chris K. There is no hard and fast rule. For the Investing Club, we tend to view 5% as our cap on position size. However, should a stock begin to exceed that level due to price appreciation, we may allow it to run a bit before taking profits. It’s hard enough to outperform the market, and even more so if you keep cutting back on the winners when they’re rallying. We don’t want any one stock to have too great an influence on overall performance. For example, in April 2022, we trimmed shares of Club stock Apple (AAPL) despite our own it, don’t trade it mantra. That’s because the name had grown to about 6.75% of the portfolio. Our sale at the time knocked it back down to about 5%. Some investors have a higher limit and that’s fine. Just know you are likely to experience more volatility in your portfolio. This 5% rule is also at odds with our view that home gamers really shouldn’t own more than 10 to 15 names. Our rule of thumb is one hour of homework per week per stock . Jim always espouses “buy and homework. As a result, owning more than 10 to 15 names can make keeping up with the homework difficult for those that have a regular day job outside of monitoring stocks. The trust may own over 30 stocks at any given time but this is supported by tireless research from Jim Cramer, two analysts, and a team of dedicated reporters and editors. If you only own 10 names, the position size limit moves up to 10% to stay fully invested (less if keeping some cash). As long-time members know, we advise that the first $10,000 invested go into a diversified index fund such as one tied to the S & P 500. This will ensure you reap the benefits of diversification from the very start. As your stock portfolio grows, you can always use this vehicle as a way of getting more money to work while keeping individual stock positions to a comfortable level. For example, you can own 10 stocks at 5% each, keep 10% in cash and allocate the other 40% to the index fund (which would in turn divide that 40% across hundreds of names). Those are just a few examples but not the only ways to think about sizing your positions. The appropriate mix will depend on how much time you can allocate to weekly research, your risk tolerance — and ultimately, whatever lets you sleep at night. Question 3. You have a price target listed for each stock. Is this price target the price you are going to sell the stock at when it gets there or is this just the price target other have on the stock? Thank you. — Steve S. A price target represents what we believe to be a fair value for the company in question. Whether we opt to sell a stock when it achieves our target is largely dependent on how and why it got there. For example, if our price target is based on an earnings projection and valuation multiple and those targets are achieved, we may opt to exit or book some profits as this would tell us that shares are now trading at fair value. Remember, we want to buy undervalued stocks and sell overvalued ones. It’s possible that shares hit our target and remain undervalued. For example, if earnings projections are revised higher, the stock may go up and stay cheap based on forward earnings projections. Club name Nvidia (NVDA) — Jim’s other own it, don’t trade it stock — recently surged and actually got cheaper thanks to the magnitude of upward earnings revisions. In this case, we may revise our target without selling anything on the belief that shares remain undervalued and can still move higher. Given that we generally base our targets on a forward earnings estimate, we tend to revise our target when new information relating to these forward estimates is released, such as an investor day presentation or earnings release. At the end of the day, a price target is simply the end result of many inputs. An analysis of the industry, competitive landscape, operating environment and macroeconomic backdrop will all go into developing an earnings projection. At the same time, a view on growth and study of past valuation and peer multiples will help develop an appropriate multiple. The product of these two items, the earnings projection and target multiple, will determine the price target. For this reason, it’s important not to put too much into price targets when determining if the stock is a buy or sell and think more about the underlying fundamentals. The fundamentals determine the price target, not the other way around. (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.

Free America Network Articles