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CANSLIM Overview

L is for Leaders

"The first man gets the oyster; the second, the shell."

- Andrew Carnegie, Steel Tycoon

The fifth thing to look for according to William O'Neil's CANSLIM stock picking method is whether a stock is a leader or a laggard. It's important to understand what O'Neil means here. He's not talking about a leader in an industry. He means stocks that are leaders in the stock market. He's talking about momentum.

In fact, the industry leaders - the giant well-established corporations - are often "sentimental, draggy slowpokes" rather than the dynamic stock market leaders we're looking for.

He cites, for example, the computer industry in 1979 and 1980. Industry giant IBM languished, while snappy upstarts Wang Laboratories, Datapoint and others soared. IBM may have been the industry leader. It was not the market leader!

How do you find these market leaders? Relative Price Strength. This measure compares a stock's price performance to the overall market as represented by the S&P 500, the TSX Composite Index, or some other standard over a certain period of time.

Observers of today' market will have noticed that there is a great deal of difference in the action of the major indices. The NASDAQ and the TSX soared while the Dow languished for the latter half of 1999. In the tech washout of March and April of 2000, the Dow did better.

The S&P 500, on the other hand, is a very broad-based standard. The widest standard is the Wilshire 5000 which encompasses almost every publicly traded US company. It is the standard that the Hulbert Financial Digest uses in measuring the performance of various stock market newsletters.

Whatever standard is used, the Relative Price Strength is calculated by taking the stock's performance over a specified length of time (O'Neil suggests six months or a year) and comparing it to the stocks in the market index. The result is a number between 1 and 99 which is much like the centile figures given on SAT tests. A number of 85 means that the stock you're looking at outperformed 85% of the stocks on the index.

O'Neil points out that "the 500 best-performing equities from 1953 to 1993 averaged a relative price strength of 87 just before their major increase in price began". In other words, if you can find emerging market leaders, you probably have a winning stock.

O'Neil recommends buying only those stocks with a relative price strength of 80 or more.

Beware of Sympathy Plays

O'Neil warns that success begets imitation. When a company becomes a market leader through some new innovation, other companies are quick to join the bandwagon. Witness the Internet explosion as a prime example. And some market analysts and stock brokers will urge clients into a sympathy play. The leader stock has advanced sharply. "The P/E is too high. It's too expensive. Try this similar stock which isn't so pricey."

That, says O'Neil, is a big mistake. You want the leader, not the wannabe. You want the oyster, not the shell! And such sympathy plays often turn out to be duds.

Market Corrections

While stocks with a strong relative price strength outperform the market, they also tend to underperform the market during a correction. O'Neil's studies have shown that growth stocks will correct 1 1/2 to 2 1/2 times the market average. So in the severe market correction of March and April 2000, when the NASDAQ lost 35% of its value, many leading stocks lost considerably more than that.

The stocks that lose the least - in other words, the stocks best surviving the downturn - are the strongest and the best bet for a strong recovery.

On the other hand, you want to look out for stocks suffering a sudden and unexpected decline. This could be a warning sign of trouble to come. This is particularly so if it is the first major price break a stock encounters in its bull run.

But if a stock actually gains during a market correction, that is a sign of unusual strength. Such a stock could well become a big winner.

Finding Mo' Better Stocks

By mo' of course, we mean momentum! And there are a variety of resources to find such stocks. One, of course, is O'Neil's newspaper, Investor's Business Daily, which lists the RPS alongside each stock daily.

Another method is to subscribe to newsletters focusing on a momentum approach.

Professor Stephen Foerster of the University of Western Ontario Business School, his Ph.D. student John Schmitz and equity analyst Anoop Prihar studied the stocks making up the TSE 100 and concluded that a portfolio of the top ten stocks calculated on a weighted average of performance over the previous four quarters and rebalanced quarterly tended to outperform the TSX Composite average. The study covered the years 1978 to 1992 and produced an average annual return of 37.0% (after transaction costs) as against 13.4% for the TSX.

 

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