6/26/08

Growth Investing and William O'Neil

This is the first in a series of posts about noted investing masters and the strategies that made them so successful.

I begin with William O'Neil, one of the quintessential growth investors. He is probably best known for his newspaper, the Investor's Business Daily. The publication is a treasure trove for growth investors. It has very short news summaries, lots of charts and even more stock statistics, like stocks' earnings rank and relative strength, that are usually not found in regular business newspapers like the Wall Street Journal. Bill O'Neil also wrote a book, How to Make Money in Stocks. It details everything the master investor learned about growth investing.

The CAN SLIM System

O'Neil calls his growth investing system CAN SLIM. It is an acronym that stands for the following: Current earnings, Annual earnings, something New happening at the company, Supply of stock, Leader, Institutional investors, Market movement.


A winning growth stock, according to O'Neil, must have the following:

1. Current earnings are up at least 25%. Quarterly sales should also be up at least 25%. Both current earnings and sales growth should be accelerating. That is, current earnings and sales growth have to be larger than earnings and sales growth last quarter. An example of accelerating earnings is having earnings growth of 10% in the first quarter, 15% in the second quarter, 20% in the third quarter, and so on. O'Neil prefers for the pace of acceleration to be accelerating as well. That is, not only should earnings growth be accelerating, it is helpful for the rate of acceleration to be accelerating as well. An example of decelerating earnings is earnings growth of 20% in the first quarter, 15% in the second quarter, 10% in the third quarter, and so on.

2. Annual earnings per share should have grown at least 25% (preferably over 50%) in each of the previous three years, and should have been accelerating over the past five years. You should look for companies whose earnings estimates predict further accelerating growth. Additionally, annual return on equity should be at least 17%, and if possible, margins should be expanding. Sales for the last three quarters should also be accelerating.

3. Some New catalyst should be there to drive the stock's price to new heights. This could be a new product or service, a new and better management team, some change in the company's industry that will help the company, new government regulations that will help the company, etc. Whatever the something new is, it has to have a positive impact on the company's future.

4. The Supply of the company's outstanding stock should be small and the demand should be large. An indicator of growing demand is the stock's volume growing as the share price rises. All things being equal, stocks with less shares outstanding will perform better than stocks with more shares outstanding.

5. The stock has to be a Leader in its industry. That is, the stock should have the best relative price strength in its industry, and the industry in which the stock is should also be a leader. For example, in 2007 and the first half of 2008, the leading industries have been agriculture (think of all the soaring fertilizer stocks) and energy. The laggards have been the home builders and financials.

6. Institutional investors should be buying up shares of the company. This requirement is sort of an addendum to the supply/demand requirement. Pension plans, insurance companies, mutual funds, banks, and governmental investors are a great source of demand. They should be buying shares of the target stock.

7. The Market must be in a confirmed upward trend. You can find a stock that fits all six of the above requirements, but if the market is in a downward trend, you will probably lose money. Only buy a stock that fits the above six requirements when the DJIA, S&P 500, and Nasdaq are all going up. O'Neil advises that you watch the daily price and volume charts of the major indices to determine when the market is in a confirmed upward trend.

A quasi-requirement, one that need not be fulfilled but that is helpful, is that the target company have a clean balance sheet (the less debt the better). Another suggestion is that management should hold a significant stake in the company.

Besides the seven step method, O'Neil has the following tips:

When to Buy

Let's say you find a stock that fits the six requirements, and requirement number 7 is also met. O'Neil suggests you should buy the stock at the "pivot point." This is where the stock begins moving to new highs after a consolidation period, a relatively flat trading range over a period of time that can range from days to months.

Don't worry about the stock's valuation measure, like the P/E. It's ok if it's high. O'Neil suggests that the market always values stocks fairly. Cheap stocks are cheap for a reason, and they can always get cheaper. On the other hand, stocks that seem too expensive can rise even higher.

Stop Your Loses, Don't Average Down

Whenever new money put in a stock losses 8%, O'Neil says you should sell it. So, let's say you buy stock XYZ for $1,000. If the stock price falls and your position is now worth $920, you should sell it. Or, suppose it does well or stays flat, and you add new money to it (see below). If the stock then goes down and you're losing 8% on the new money, you should sell the new position. If the original money isn't losing 8%, you should keep it. That is, treat each buy as a separate position. Sell those positions that lose 8%.

The reasoning here is that it's harder to make up loses, and stocks can always keep dropping. For example, if a stock drops 50%, it has to double for you to break even.

O'Neil thinks you should always sell the worst performing stocks first. He uses an analogy of running a store to argue against averaging down. Imagine you run a store where you have two products, A and B. Let's say A sells very well and B sells poorly. When preparing for a shopping holiday, which would you stock up on? A obviously, and you'd certainly ditch B.

Averaging Up

O'Neil calls averaging up "pyramiding." This follows on the retail store analogy above. You should buy more of your winners, and get rid of your losers. Weeding out your losers is supposed to stop your loses. Buying more of your winners is supposed to increase your profits. The reasoning here is that you don't have to be right all or even most of the time; you just have to lose less than you gain.

O'Neil recommends putting more money into a stock up to 5% from the previous buy point. He says not to add more money if a stock has risen higher than 5% from the buy point.

Don't Diversify

Your CAN SLIM portfolio should have only a few stocks. First, there aren't many stocks that fit all the requirements anyway. Second, "the best results are achieved through concentration." You should "have one or two big winners rather than dozens of very small profits."

When to Sell Winners

You should keep your stocks at least for eight weeks (unless they start losing 8%). Sell when your stock rises 20%. If this happens before the minimum eight week holding period is over, keep the stock until the eight weeks are up, and then evaluate it with the CAN SLIM method to see if it has the potential to go higher.

Just as you should build your position gradually (up to 5% above your entry price), you should sell gradually as well.

My Opinion

I hope I have not been biased in my summary of O'Neil's system for investing in growth stocks. While there are some points to be made about the advantages of O'Neil's system, I wouldn't use it myself.

Here is what I think is good about CAN SLIM. The instructions, for the most part, are precise. It seems not very hard to follow them step by step. Additionally, the six requirements seem rigorous enough to weed out most terrible stocks. Adding money to your winners can also be good advice.

Nevertheless, I don't like the system.

1. It seems to be a risky one considering that we're only going for a 20% gain. The first six steps virtually guarantee that you will find stocks with huge investor expectations. Such stocks, with accelerating earnings, usually have big P/E ratios. While I don't think the P/E ratio is a tell all by any means, if the company stumbles and does not deliver on expectations, even by a small amount, its share price can plunge. A stock with a P/E of 100 can easily be sent down to a P/E of 80.

2. I have a lot of trouble with step 7. How do you determine that the overall market is in an upward trend? Sure, hindsight is perfect, but how do you know while it's happening? I've always been skeptical about using charts to predict market movements. Most moves, up or down, in my view anyway, seem to be correlated with news. Last summer, the DJIA was making record highs. Let's say you started the CAN SLIM method near the peak. You found a couple of stocks that fit the first six steps. At step 7, you surely would have thought the market was in a confirmed upward trend. Then August came and subprime was back in the headlines. So much for a confirmed trend.

Or more recently, think of the latest stock market drop in March 2008. The DJIA fell below 12,000. It rose over April and May back over 13,000. Today, 6/26/08, it's back down below 12,000. How is an investor to do step 7?

3. The 8% stop loss requirement is silly. While it brings a measure of discipline--follow the plan and don't succumb to emotions--I don't think it's good advice with the kind of stocks you'll find with O'Neil's system. As I said above, these stocks most likely have high P/E ratios. This makes them more likely to be volatile. You can suffer a 10% loss in one day. On the system's rules, you should sell. But how will you feel when the stock rebounds over the next few days and weeks?

It's not at all uncommon for growth stocks to fall and rise at double digit rates over a short period of time. Here's a recent example from my own trading.

4. How do you know where the pivot point is? Again, it's easy to find in hindsight, but very difficult when it's actually happening.

5. I'm a firm believer in averaging down. It's the only way, short of luck, to get the best price for a good company. Mind you, it has to be a good company (or should I say great company?). Averaging down on a POS, as they call it on the Yahoo Finance message boards, will just lose you more money.


If you are interested in learning more about the CAN SLIM system, I suggest you pick up a copy of Investors Business Daily.

You might also be interested in a mutual fund that uses the system to select stocks: the CAN SLIM Select Growth Fund (CANGX). It has been very volatile, as you may have suspected.