This post is the first in a series I will be writing about the development of the core stock trading strategy I follow in my newsletter. In this post I will cover the well known CANSLIM methodology created by William O’Neil, founder of Investors Business Daily.
The first trade I ever made in the stock market came around 1991 or 1992. I think I made a trade based upon a recommendation in a newsletter/magazine written by Jonathan Steinberg. I think it was called “Individual Investor.” Steinberg is married to Fox Business’ Maria Bartiromo and runs Wisdomtree Investments.
In any event, I was only a brief subscriber to that publication and to a couple others when I came to realize that following that type of newsletter is not going to be helpful in the long run.
At some point, I turned to Investors Business Daily. Along with my subscription to that publication, I received a copy of O’Neil’s book How to Make Money in Stocks
In his book, O’Neil outlined his strategy for investing in stocks…the CANSLIM method. This was the first time I was exposed to stock market data that focused on price action and technical analysis, rather than just fundamental analysis.
Based upon my experience, I think this is an excellent place to start for anyone interested in building wealth in the stock market.
Let’s see what CANSLIM is all about….
CANSLIM is an acronym for…
C = Current quarterly earnings per share
A = Annual earnings increases
N = New Product, New Management, New Highs…buying at the right time
S = Supply and Demand…small capitalization plus volume demand
L = Leader or Laggard?
I = Institutional Sponsorship
M = Market Direction
Here is the basic idea behind the strategy…
CANSLIM PART 1 – Current and Annual Earnings Growth (C&A)
First, you look for companies that are exhibiting strong earnings growth…both on a quarterly basis, and on an annual basis
You basically want to see 50% earnings growth in the most recent two quarters and at least 15% annual growth.
When you conduct a screen of the stock market for these types of stocks, you’ll end up with a pretty narrow list of candidates. This is especially true during bear markets because a weak economy will have a significant impact on earnings.
CANSLIM PART 2 – New Highs, New Product, New Management (N)
Next, you want to screen for stocks that are about to make new 52 week highs. You only want to buy stocks that already have upside momentum.
This is the OPPOSITE of what most people think you should do, which is buy low and sell high.
However, the CANSLIM approach is essentially a trend following approach to trading. In this regard, you want to buy high, and then sell at a higher price.
Also, you want to look for stocks that have a hot new product…the I-POD developed by Apple a decade or so ago is a great example. If a company doesn’t have a hot new product, perhaps they have new management capable of getting the company back on a path to strong growth.
Ultimately, when it comes to the “N” in CANSLIM, new 52 week highs is the most important indicator.
CANSLIM PART 3 – Supply and Demand (S)
Basically, smaller cap stocks will have limited shares. Therefore, shares of a smaller cap stock with a hot new product will be in high demand…that imbalance is what will drive share prices higher.
CANSLIM PART 4 – Leader or Laggard (L)
Quite often, an entire industry or industry group of stocks will rise at once.
For instance, last year, as silver prices were starting to percolate again, silver mining stocks started to rally. However, they did not all rise at the same pace.
If you find a stock that is moving higher, look at its industry strength. If most stocks are moving higher, and yours is a leader…BUY the leader.
This is also different than what most people will do…they will think a weaker stock should eventually catch up.
However, a weaker stock may have a problem with too much debt, poor management, etc. Stick with the LEADER of the group.
CANSLIM PART 5 – Institutional Sponsorship
This is basically a lagging indicator.
The premise is that if a hot stock is being bought by institutional players such as mutual funds, then it stands to reason that other such players will jump on the bandwagon. However, you don’t want that sponsorship to be too heavy, otherwise no one else will be left to buy. You simply want some institutional investors buying the stock. As it rises, more will pile in.
Investors Business Daily will provide information on institutional sponsorship in a stock.
What I personally like to see is a jump in volume as the stock is rising in price. If at some point in the last year or so you see a major spike in volume, then it’s a good bet that the stock is attracting some institutional buyers.
CANSLIM PART 6 – Market Direction
If the market is in a bull phase, most stocks will rise. If it is in a bear phase, most stocks will fall. As such, you want to be more aggressive in bull phases, and cautious or in cash during bear phases.
Forecasting the stock market is quite tricky, however. O’Neil presents thoughts and ideas on how to forecast market direction, but it is all quite subjective.
It helps to pay attention to sentiment indicators, such as investor surveys to look for too much bullishness or bearishness. These surveys should be used as contrarian indicators.
Fewer stocks making new 52 week highs should also be a warning sign for a market that is making new highs.
A market that is making new highs with lower volume, and then selling off with high volume is also bearish.
These are subjective indicators. Ultimately, if the overall market is breaking down in price after a long run, it pays to be cautious.
Ultimately, the best time to buy stocks is when everyone is bearish after a long decline. March 2009 is a great example.
However, few stocks will be making new 52 week highs right then. You still need to wait. Patience is king.
Keep this one thought in mind…making big money in the market does not mean you need to be trading every day, every week, or even every month.
CANSLIM PART 7 – When to Buy a Stock
One of the big topics presented by O’Neil is the determination of the precise time to buy a stock. As mentioned, you want to only buy stocks that are going up in price.
However, you don’t want to buy them when they are EXTENDED in price…they will be due for a correction.
O’Neil identified some “basing” patterns that he looked for in stocks that had strong earnings momentum.
When the stock breaks out from this “base” he would buy. Let’s look at an example.
This is a chart of Netflix in 2015. In late 2014 to early 2015, it forms a Cup with Handle Pattern. It broke out in June, and proceeded to rise over $40 after the breakout.
O’Neil also indicates that after buying a stock, he would have a mental stop to sell the stock if it declined by 7% to 8% below his buy price.
In other words, if he bought at $100, he would sell at $93 or $92. This is an example of “cutting your losses short.” All successful trend followers live by this motto.
Amateur traders don’t like to be wrong, so they will hope a stock goes back up. Ultimately, they may end up with huge losses, which results in less capital to trade with when the next opportunity arises.
Final Thoughts on CANSLIM
There are a couple of issues I have with the CANSLIM methodology for trading stocks. First of all, the stop loss is somewhat random and not based upon the price action of the stock itself.
When stocks are getting ready to make new highs, they can become volatile, and start moving at a clip of 5% or more per day. Therefore, a 7% stop loss may be too tight. On the other hand, if a stock is a slow mover, that stop loss may be too wide.
O’Neil also does not provide any specific rules for exiting positions. That is absolutely crucial to the success of a stock trader.
Finally, O’Neil does not talk much about risk management. In fact, he makes it clear that he is willing to take on a lot of risk in order to hit a big winner. He recommends that a new investor with only $5,000 in their account should just trade one stock. This implies that the investor would bet the entire account on one stock.
In my experience successful traders will employ sound risk management in addition to having a good strategy in place for buying and selling stocks.
So there you have it, the basics of the CANSLIM methodology. Again, I highly recommend O’Neil’s book, so if you don’t have it, get it!