” Remember that estimates are opinions, and opinions may be wrong. Actual reported earnings are facts.” Quote by William O´Neil
Stock Broker, Founder and Author
William O’Neil is a stock broker and founder of the financial business newspaper Investor’s Business Daily.
William O’Neil is mostly known for developing CANSLIM which is a short-term growth stock investing strategy.
William O’Neil is the author of How to Make Money in Stocks which features the CANSLIM strategy.
CANSLIM
CANSLIM is basically a combination of fundamental analysis and technical trading, and can be thought of as fundamental trading.
The CANSLIM strategy uses fundamental analysis to find stocks that deserve to go up and uses technical analysis such as chart patterns to time the entry.
Once a position is taken, the CANSLIM strategy uses trade management techniques such as a stop-loss and a profit target.
CANSLIM is an acronym with each of the seven letters standing for:
CANSLIM
- Current Quarter Earnings per Share
- Annual Earnings Growth
- New Products, Management and New Highs
- Supply and Demand
- Leaders
- Institutional Sponsorship
- Market Direction
Each of these seven components is discussed as follows:
Current Quarter Earnings per Share
The earnings from the last quarter reported should have a minimum 25% increase over the previous corresponding period (same quarter from a year ago). The 25% figure is a minimum but 50% or more is preferred.
The higher percentage increases are preferred as the CANSLIM strategy works better with large percentage increases in earnings.
The income statement should be checked to confirm that the earnings are from the businesses normal operations.
Non-reoccurring items from the sale of asset such as real estate will distort the reported earnings figure and any one-off items should be deducted – what is important is an increase in normal reoccurring profits.
The quarterly earnings from the last two years should be checked and they should show a fairly consistent increase in quarterly earnings with the current quarter having the largest percentage increase.
It is preferred if the quarterly earnings are showing an accelerating increase.
Also check the quarterly earnings for the next quarter from the previous year. With some companies their earnings are seasonal and with other companies their result may just have been a low result.
A lower earnings figure will be easier to beat when next quarter reported.
The analysts’ forecasts for next quarter and for next year should be checked. It is preferred if these are showing an accelerating increase in earnings.
Also the quarterly and annual revenue growths should be checked to see if they are showing an increase to justify the earnings increase.
Annual Earnings Growth
The annual earnings should be 25% or more over the previous year. Also the annual earnings should have increased in each of last three years. The earnings increase should be consistent and preferably accelerating.
Any companies with an erratic earnings history should be avoided.
The CANSLIM strategy looks for the earnings growth rate to be increasing. Also the revenue over the last three years should be consistently increasing.
Companies with a high Return on Equity of 20% or more are preferred.
The CANSLIM strategy is not concerned with the stocks PE ratio which means that the stocks are usually bought at high multiples due to the strong earnings performance.
New Products, Management and New Highs
Normally it requires something new to produce strong growth in a company’s revenue and earnings.
The something new can be a new product or service that consumers must have – this is also a good way to boost revenue and earnings.
Even a change in management which has a new direction for company or improves efficiency can have a positive effect on revenue and earnings.
Simply marketing an existing product in a new innovative way can have a positive effect.
Sometimes the change is within an industry – products or services that were out of favor are now in favor. Significantly improved industry conditions are a good way to boost revenue and earnings.
Also new technology to make the same products cheaper will boost revenue and earnings.
The CANSLIM strategy involves stocks when their price makes a new high and consolidates.
Supply and Demand
Due to the strong growth requirements for the CANSLIM strategy most large-cap stocks tend to be excluded.
Generally the smaller companies have greater potential for growth which provides the advantage that they have fewer shares outstanding – the stock price can more easily be driven higher when there is a limited supply of shares.
Management should own a fair amount of stock. This is highly desirable since they then have a personal interest with increasing stock price.
They tend to be more entrepreneurial and are closer to the actual business operations, as they tend to treat the company as their own.
Management that do not own a lot of stock tend to just run the business without any incentive to increase the stock price.
Generally it is better if there are no recent stock splits or if there are then the split is small such as 2-for-1.
Large stock splits significantly increase the shares and since the stock price is usually high it tends to motivate stockholders’ to sell some of those shares to lock in a profit – which tends to drive stock prices down.
Usually it’s a good sign a when company is buying back its shares, especially when the stock price is high.
This reduces the number of shares and thus increases the earnings per share.
A bonus is that the company feels comfortable that their retained earnings are not needed because it expects further increases in earnings.
Leaders
The CANSLIM strategy looks for the stronger stocks in an industry group.
The strength is measured by the relative strength of the stock price advance compared to the industry group index.
The CANSLIM strategy suggests that only the top three stocks in an industry group are considered (based on relative strength). These are the stocks that are significantly outperforming the market.
The industry leader is not based on revenue – it is not the revenue leader.
In other words, a large company may be dominating the industry based on dollars of revenue, but their stock price is probably only moving along with the industry index since the large companies dominate the indexes performance.
This is because industry indices are capitalization weighted and the performance of an industry index is largely due to the performance of the large-cap stocks.
What the CANSLIM strategy looks for are companies whose stock prices are outperforming the industry index, which means that the stock must be a smaller company which does not dominate the indexes performance.
Institutional Sponsorship
Institutions are large investing entities such as mutual funds, pension funds, hedge funds and insurance companies.
Institutional sponsorship is the amount of shares owned by these institutions. Large-cap stocks are typically dominated by institutions due to their high liquidity.
As the companies become smaller the amount of institutional ownership declines, both in the number of shares they own and in the number institutions which own the stock.
Due to the large number of shares institutions need to buy, attracting new institutions to the stock provides a significant boost to the demand for the relatively limited amount shares available.
When buying the stock, it is beneficial if there are already some institutions owning the stock, but not too many.
This is so that there is still plenty of room for new additional institutions to become stockholders and to do so they have to buy stock from the retail investors – this buying demand from the institutions is what pushes the stock price up.
It is preferable if the number of institutions has been increasing over last couple of quarters.
New institutions that bought stock in the last quarter are not likely to sell in the next quarter, but will probably add to their position.
It is even better if any new institutions are mutual funds with a good recent track record of performance.
This is likely to attract the attention from other institutions that do not currently own the stock.
Market Direction
Buying high priced growth stocks is a bull market strategy and will produce negative returns in bear markets.
Pullbacks in bull markets occur all the time and are generally not a major problem provided the correction is not excessive as the temporary decline is usually brief and the market starts to climb again.
If the market pullback becomes excessive (say 5% to 10%) then it is best to suspend any new position entries and closely monitor any open positions.
By waiting the investor can look for conformation that bull market will continue. If there is no conformation, then it’s likely that a bear market has developed.
A resumption of the bull market occurs when a market rally trades above the relative high of the previous market rally.
Trading Strategy
The CANSLIM strategy is a short-term investing strategy – it is generally not intended for long-term investing and is definitely not suited to buy and hold investing.
The fundamental analysis is purely to locate stocks that have a good reason to rally (a short-term burst).
The actual entry decision is based on technical analysis and uses chart patterns.
The CANSLIM strategy looks for stocks making new highs and pulls back from that high to consolidate for several weeks to a month or more.
An entry is taken once the stock breaks out to the upside from its consolidation pattern.
The CANSLIM strategy allows for pyramiding should the investor prefer to pyramid.
Pyramiding is a trading tactic Jesse Livermore is famous for and simply means taken a small position initially and if the stock price advances then additional positions are taken each at higher prices.
The final position should be at a price that is no more than 5% above the breakout level.
Due to the high prices typically paid, it is essential that a stop-loss is implemented. The CANSLIM strategy is a longer term strategy than position trading and thus requires a wider stop level.
CANSLIM suggests using a fixed percentage stop rather than a chart pattern based stop.
The stop-loss should be 8% below the entry price and this figure was derived from historical back testing as being the optimum figure to use.
The CANSLIM strategy suggests using a profit target of 20%. If the stock takes more than three weeks to reach then it should be sold at the profit target.
However the CANSLIM strategy states that if the stock reaches the 20% profit target in three weeks or less, then the stock should be held for eight weeks and stop-loss level raised up to the entry price.
After eight weeks, raise the stop-loss up to the 20% profit target and look for signs to exit. These signs include:
Exit signs:
- The largest daily high-low range after the stock has a big run up in price
- The largest daily volume after a big run up in price
- A gap up day after big run up in price
The CANSLIM strategy will usually see most trades exited within a month or two.
Big moves typically occur quickly out of the consolidation pattern and shoot past the 20% level fairly quickly and this is why they are held for a bigger move, which can last for six months.