William O’Neil: The Art of Stock Selection

William O'Neil is the author of the book “How to make money in stocks”. He is also the founder of a business newspaper Investor's Business Daily. He is the inventor of the CAN SLIM trading system. The rules that he emphasizes on as the most important ones are CAN SLIM, which represents specific conditions that should be met before William can buy a stock.

The rules of his ‘CAN SLIM’ model are as follows:

• ‘C’ signifies the current earning per share of a company. The quarterly earnings per share must be up by at least 20-50% on a year to year basis.
• ‘A’ signifies annual earnings per share. He concluded that the best performing stocks have an increase of 24% on a year to year basis and ideally each consecutive year has beaten the year before..
• 'N’ means something new. New refers to either a new product or change in the industry or a new management of the company. It makes sense that for a stock to reach new highs, something new must happen or has happened recently to support that price increase.
• ‘S’ means shares outstanding. Most companies have less than 25 million shares outstanding at the time of their greatest performances.
• ‘L’ means Leader or Laggard. If a stock is a leader, it has been out performing most of the other stocks during the last 12 months. If it's a laggard, it has on the contrary, been performing worse than the rest of the pack.  He suggests picking only leaders that have been out performing at least 80% of its peers.
• ‘I’ means Institutional Sponsorship. The biggest source of demand comes from the institutional investors. He suggests looking for the companies where there are institutional owners who are among the top performers in the Asset Management Industry, and where the number of institutions owning the stock has increased when compared to the previous year. When a firm establishes a new position, chances are that it will add to that position later which will cause an increase in the price.
• ‘M’ means market direction. 3 out of 4 stocks will go in the same direction as the market averages. It is therefore very useful, according to O'Neil, to learn how to interpret price and volume in the market averages to look for times the market has topped or bottomed.

He tells us how to differentiate between a market top and a normal bull market correction.

First, the average moves up to a new high, but with a low volume. This shows that the demand for stocks is poor at that point and that the rally is vulnerable. 

Second, volume surges for several days, but there is very little increase in the closing price. In this case, there may not be an increase in volume when the market initially tops, because the distribution has taken place on the way up. Another way to understand the market direction is to focus on how the leading stocks are performing. A major sign the market has topped is if the leading stocks of the bull market start breaking down. Another important factor is the FED discount rate. Usually, after the FED raises the rate, the market runs into trouble. The daily advance/decline line is a useful indicator which gives signs of a market top.

While talking about Relative Strength, he thinks the key point is how far a stock has extended beyond its most recent price base. One must buy stocks that have a high relative strength and are just beginning to emerge from a sound base-building period. However, He doesn't generally buy a stock with a high relative strength that is already more than 10% beyond its prior price base.

He advises that a stock should never be sold short because its price looks too high. The idea is not to sell short at the top, but at the right time. Short selling should only be done after the market shows signs of a top. The best pattern to short is one in which a stock breaks out on the upside of its third or fourth base and then fails. Before selling any stock short, the price to cover the short position should be decided if a loss occurs.

William sticks to a rule of never losing more than a maximum of 7% on any stock that he buys on the basis of Price to Earnings or P/E ratio. He condemns from the belief that a stock is undervalued because it is selling at a low P/E ratio. The average P/E ratio of the best- performing stocks at their early stage was 20, compared to an average P/E ratio of 15 for Dow Jones during the period of 1953-1985. At the end of their expansion phase, the same stocks had an average P/E ratio of 45. This means that if, in the past, you overlooked stocks with above-average P/Es, you missed most of the best performing securities. A common mistake that investors make is to buy a stock only because the P/E ratio looks cheap. Similar mistake is selling stocks with high P/E ratios.

He also says that there is no correlation between dividends and a stock’s performance. According to him, if a company pays more dividends then it may have to pay high interest rates to replace the funds.

Finally, he says that successful trading requires 3 key elements. An effective trade selection process, risk control and enough discipline to stick to the first two rules.