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Book Review

How to Make Money in Stocks
by William J. O'Neil
reviewed by Marco den Ouden

Originally published at About.com - Jan. 13, 2000

"I never buy at the bottom and I always sell too soon."
                                                                               
- Nathan Rothschild

Conventional wisdom about winning in the stock market, while it may be conventional, usually isn't very wise. So says William J. O'Neil, founder of Investors Business Daily. Consider these cliches:

  • Buy Low, Sell High.
  • A stock that's run up in price is too expensive. Buy cheap stocks.
  • Buy on dips.
  • Hot tips are a good reason for buying a stock.
  • Big name companies are better investments than small unknown companies.
  • Don't sell at a loss.
  • If a stock drops in value, dollar cost average down to reduce your cost price per share.
  • Market timing is impossible.

These are just a few of the myths that O'Neil dispells in his investment classic, How to Make Money in Stocks. First published in 1988, the book was revised and re-issued in 1995. It is still a great read today.

As a young stock broker O'Neil set out to study the greatest growth stocks in history to see what set them apart from the others. Eventually this became a 40 year study he calls The Record Book of Greatest Stock Market Winners. He studied over 500 of the biggest market winners from 1953 to 1993. Stocks like Texas Instruments, Xerox, Dome Petroleum and Cisco Systems in their heydays.

Distilling this information, he developed a popular system of stock analysis called CANSLIM. And it is anything but a diet fad!

CANSLIM

CANSLIM is an acronym for the seven selection criteria O'Neil says you should consider when choosing a stock. The letters stand for:

  • C - Current Quarterly Earnings per Share - Major stock market gainers all showed a major increase in current quarterly earnings per share over the same quarter the previous year. 3 of 4 stocks he studied showed increases of over 70% before the stocks made their big moves.
  • A - Annual Earnings Increase - The stocks studied showed an annual average compounded growth rate of 24% a year over the previous five years. Many were much higher.
  • N - New Products, New Management, New Highs - The market likes good news, whether it's a new drug for a pharmaceutical company, or a new product completely, or even new management (turnaround stories) or a stock reaching new highs. 95% of the stocks O'Neil studied had major new products, new management or other significant change in the business.
  • S - Supply and Demand - Now here's one so obvious yet so often overlooked. In fact, O'Neil says "The law of supply and demand is more important than all the analyst opinions on Wall Street." What's it mean? For one, a small number of shares outstanding is better than a large number (supply is limited). Trading volume is an excellent indicator of supply and demand. Volume should increase substantially on rallies and dry up on corrections. (The latter indicates that current holders of the stock are reluctant to sell at lower prices.)
  • L - Leaders - You want to buy stocks that are moving ahead of the pack - the market leaders, not the laggards. A good measure of this is relative price strength. The stocks O'Neil studied had a an average relative price strength of 87 just before their major price breakouts. This means they were already doing better than 87% of the stocks in the market place before they really jumped.
  • I - Institutional Sponsorship - There should be some interest developing in the stock by mutual funds, pension funds, insurance companies, etc.. Large buying stimulates price moves. At the same time you don't want a stock to be "overowned" by institutions.
  • M - Market Direction - By far the trickiest and most complex of O'Neil's criteria. He argues that you cannot do well by fighting the market. If the broad market is trending downwards, three out of four of your stocks will slump with it.

This fascinating method of stock picking has developed quite a following and more than a few websites of enthusiasts. But CANSLIM is just a part of O'Neil's book. He also includes two chapters on when to sell, perhaps the most important tool in an investor's arsenal.

These chapters are, in my opinion, even more important than the CANSLIM chapters. One of the most important rules O'Neil has is to limit your losses. The average investor hates to sell at a loss. The reluctance is palpable. I know. I've been there. Most people want to sell their winners and hang on to their losers in the hope they will turn into winners.

O'Neil, in fact, recommends just the opposite. Cut your losses short and buy more of your winners. Don't dollar cost average down as a stock declines. Average up as it rises.

More than a few times when I've mentioned a great stock to someone, a stock that has been climbing steadily, I've heard them say "But it's now too high. I'm afraid to buy it at this price." And I've felt that way on occasion too. But the best performing stock I bought last year was Qualcomm which I bought after it had risen from $25 to $205. I bought more at $370. It finished the year at over $700 (pre-split).

On the other hand, I did not follow O'Neil's rule of cutting my losses and watched one penny stock I bought at $0.32 zoom to $0.42 and then quickly slide all the way down to $0.04. O'Neil recommends never taking a loss of more than 7 or 8% on any investment. As a stock rises you can raise your pre-determined selling point and allow for greater fluctuation, but cut your losses short whatever else you do. The great financier Bernard Baruch said "Even being right three or four times out of 10 should yield a person a fortune if he has the sense to cut his losses quickly on the ventures where he has been wrong."

But when should you sell your winners? O'Neil writes how he made a small fortune by averaging up on selected winning stocks, and then watched the profit evaporate as the stocks all declined again. "I was so mad," he writes, "that I spent the last six months of 1961 analyzing every transaction made during the prior year."

He discovered he had no selling plan. "Like the majority of people's, my stocks went up and down like a yo-yo and my paper profits were wiped out."

His studies turned up a number of useful ideas and he lists 36 prime selling pointers and 8 rules on when to be patient and hold a stock.

O'Neil discusses a lot of other things besides. There is an extensive chapter on chart reading and another on reading the financial press effectively which I found very illuminating.

Although the book is five years old, it is still relevant in today's market. I see the wisdom of his advice reflected in my own winners and losers. And I see it reflected in some of the better newsletters.

If you want to read one good book on investing, this is the one. It's chock full of excellent ideas.

 

Contents copyright Marco den Ouden       All Rights reserved
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