Trade Or Invest?

By James J. Cramer

Imagine that you run a mutual fund where the only investors are 98 rich people (minimum net worth: $5 million). You get paid a percentage of the gains and make nothing if the fund loses money. The risks are large, but if you're good, so are the rewards. You've just imagined my job. I'm a hedge-fund manager, a term that conjures up swashbuckling billionaires like George Soros, whose trades can drive down entire foreign economies. I'm a much smaller fish: my partner and I manage about $360 million, investing almost all of it in U.S. stocks. But like the big boys, we get to engage in one of the purest, harshest, most exhilarating forms of capitalism. I post million-dollar gains or losses almost every day, and what I learn can help you as an individual investor.

I maintain, for example, a strict distinction between investing in stocks and trading them--and so should you. My hedge fund is divided into two roughly equal pools of money. The investing side is run in the old-fashioned Benjamin Graham-Warren Buffett tradition of seeking value, mainly among small stocks like savings and loans. Here I approach each investment as if I'm buying the company: I carefully research the financials, management, customers and competitors. I don't have to know when the stock price will rise, only that it will. I don't talk about it much, but historically that investing portfolio has earned 50% of my profit.

The trading side is a different story. I run that portfolio more like a retailer than a stock picker. I need to have the merchandise that people want on hand when they want it, and if things turn bleak the next day, I want as little inventory as possible. Sometimes I even agree to deliver in the future some merchandise I don't own, because I think I can buy it later at a cheaper price. (This trading of options on the future prices of stocks originated as a way to "hedge" risks, and it's one of the things hedge funds do that a mutual fund can't.)

When I buy call or put options, I'm not investing in a company; I'm trading pieces of paper in search of short-term profits. Here the fundamentals of the underlying business are usually less important than my read of how other investors are going to respond to new developments. There's no religious faith involved. I'm dispassionate about my stock trades.

Example: Pfizer, maker of the hottest drug on the market, Viagra. Many recent buyers of Pfizer have created a cult with a sworn faith in the stock's momentum. To me, Pfizer is a fine company, for many years a core holding of mine, but now the stock has too much hype in it. I sell it routinely as it gets to $110. Does that mean I hate Pfizer? Hardly. I buy whenever it trades below $100. Why? Because there you are paying a fair price for the promising drugs that come after Viagra.

These days, more people are trading options in their spare time, and for them I have this advice: If you want to compete against me and other pros in short-term trading, quit your day job and really get in the game. Otherwise, focus on researching long-term investments. Track strong businesses that you've researched, and wait for their stocks to be oversold by traders overreacting to some short-term setback. I saw two good examples just last week: Eli Lilly and Xerox. (Full disclosure: I'm long on both stocks.) Here you can beat me and the market. You can take a longer view--not least because you don't have to report every quarter to those 98 rich guys!

Jim writes for thestreet.com an investing website. Nothing in this column is to be construed as advice to buy or sell stocks.