How to Make Money in Stocks
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
- Buy on dips.
- Hot tips are a good reason for buying a stock.
- Big name companies are better investments than small
- 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
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 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.
- 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
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
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
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.