With thousands of publicly traded companies to choose from, you may wonder how you can single out a handful of stocks that have the potential for significant capital gains. Many methods for picking stocks exist, from Warren Buffett’s value investing mentality to the Joseph Piotroski F-Score method.
One particularly useful strategy for detecting high-growth stocks uses the acronym CAN SLIM. What is this approach? How profitable is it and who invented this unique stock trading system?
Below, you will find a detailed description of this high-growth investing system that uses both fundamental and technical analysis, and how you can utilize it.
The Father of CAN SLIM
Before getting into the details of the method itself, it is important to learn a little about the founding father and his reputation for success.
From buying himself a seat on the NYSE at age 30 to running a major national paper, William J. O’Neil has established himself as great investor in many people’s minds, alongside the likes Philip Fisher, Benjamin Graham, and Peter Lynch.
In 1984, O’Neil founded the aforementioned investment newspaper, Investor’s Business Daily (IBD). A few years later, in 1988, he wrote a book called, How to Make Money in Stocks: A Winning System in Good Times and Bad. The book, in which O’Neil details the CAN SLIM method, is now in its 4th edition with over 2 million copies sold.
Since he’s sold millions of books in multiple editions, there must be something to his theories. But is his method really profitable in the long-term?
How Profitable Is O’Neil’s System?
According to the AAII website, which tracks historical returns of different trading systems, the CAN SLIM system has achieved annualized gains of 28.2% between the years of 1998 and 2010.
Inputting the data for the individual years, I calculated a cumulative gain of 2,490%, or the ability to turn $1 into $25.90 in 13 years time. By way of contrast, the S&P 500 has only averaged an annual rise of 2.4% over the past 13 years, with a cumulative gain of 29.7%. This means you would turn $1 into $1.297 with a market-based investment.
As you can see, to say that the CAN SLIM method has been successful thus far would be putting it modestly.
So now that I have your attention, let’s take a look at what the system is, and how it works.
What Is CAN SLIM?
The CAN SLIM trading system is essentially divided into two major parts. The first is a quasi-fundamental scan of picking high-growth stocks that involves quantitative and qualitative criteria; some aspects of which are tangible, while others are not. The second involves recognizing price patterns on the individual price chart of the stock.
Does this all sound pretty complex? I’ll start with the basics: What does CAN SLIM stand for and how can it help you pick high-growth stocks?
Here is a letter by letter breakdown of the acronym.
C – Current Quarterly Earnings
How much profit did the company make this reporting quarter? Now, compare that number to the same quarter last year. To qualify as a high growth stock, earnings should have grown by at least 20%. Remember to compare the same quarter period (but in separate years), since some stocks are cyclical and will have high and low profit periods.
As an example, compare the 4th quarter of 2010 with the 4th quarter of 2009. Is the growth above 20%? Now compare the 3rd quarter of 2010 with the 3rd quarter of 2009. Is the growth above 20% there too?
Things become really exciting when you find that the 2nd quarter grew 20%, the 3rd quarter grew by 23%, and the 4th quarter grew by over 25%. This means that growth is consistently accelerating, raising the chance of the stock going into runaway mode.
A – Annual Earnings
The annual earnings should also be growing aggressively between years. Compare the full year of 2010 earnings per share to the full year of 2009. The annual earnings growth should be at least 25%. William O’Neil also likes to look back over the past 5 years for consistent high-growth, weeding out stocks that have only one good year. If the growth rate is actually accelerating between years, this is even better.
N – New
This factor is all about something “new” taking place. Here are the primary examples to watch out for:
- New Products: Perhaps the company is making an exciting new product. Imagine when holographic TVs finally come out, or if a solar paneled car was approved for mass production by a large auto manufacturer. Even a new product that has the market cornered, such as a new cure for some type of cancer, could be just the product to help a company grow quickly.
- New Management: A bright new set of minds could join a company in the form of new management. Sometimes all it takes is a forward-thinker to turn a profitable business into a rocketing one that turns a company around. Xerox could have taken the commercial world by storm with their Alto computer system that included the first mouse and graphical user interface. Instead, it was the “new” management team of Apple and others that seized the concept of consumers buying personal computers and took their businesses to new heights.
- New Conditions: Sometimes you have a new condition or circumstance. Perhaps a new market, such as China, is opened up, or a new law comes into effect promoting green energy. This change of circumstance could aid certain stocks, like the ones with exposure to China, or the producer of a paint that provides solar power energy.
- New Price Highs: A new price high can also be just the cause necessary to have a giant effect. Counter-intuitively, when a stock reaches a new height, it can be a very good time to buy. As new price highs are achieved, the stock will often make a high volume breakout. Former resistance levels are broken, bulls start buying, and the stock receives high-profile coverage on many stock market analysis and research sites that list 52 week, or new record highs.
S – Supply and Demand
One of the most basic concepts in economics is supply and demand. When there is more supply than demand, prices drop. If demand exceeds the available inventory, prices rise. You want to see a massive surge in volume as the stock goes upward to show that large forces want shares, and there is not enough supply to go around. Large volume price advances reveal a shortage of supply with a steady stream of buyers.
Small, anemic volume has the opposite effect. While the supply could be experiencing a short-term restriction, thus allowing prices to drift upwards, the lack of volume betrays that demand is also tepid. If more sellers appear, there may not be a group of bulls waiting to soak up the shares.
Float size should also be taken into consideration. A small float size can create a fast-moving – albeit more volatile – stock. A larger float with too many shares can create a bloated stock that has difficulty moving up. If the share float – or the amount of outstanding shares readily available – is under 25 million, it could help provide additional lift when buying ensues.
L – Leader or Laggard?
William O’Neil firmly believes that stocks which historically perform poorly will often continue to do so (laggards), and previously winning stocks will go to new heights (leaders). This is very similar to the idea of momentum-based trading.
How do you know if your stock is a leader or a laggard? Relative Strength (not to be confused with the Relative Strength Index) rates all stocks according to price performance. A stock with a RS rating of 50 means it traded at the market average. A rating of 100 means it was in the highest percentile of price performance, and a rating of 25 means that it traded worse than 75% of all the other stocks.
William O’Neil suggests picking stocks with a RS rating of at least 70 when looking back at the past 52 weeks of historical data. Thus, your winning stock has high momentum and has higher odds off outperforming over the following year.
I – Institutional Support
Institutions buying stocks can provide strong support to share prices. In turn, buying stocks with some institutional support is following the “big money.” Look for some institutional ownership, but not so much that it is weighed down, and everyone that might want aboard is already invested. Follow these guidelines:
- Follow share prices over $20. Because most institutions prefer to invest in larger stocks with share prices above $10, the CAN SLIM approach favors stocks over $20 in price.
- Look for multiple institutions. It is also recommended that the stock have at least 3 to 10 institutions investing in it. If these institutions are high-profile and well-known, this could give more assurance to investors that “smart money” or “informed investors” are invested.
- Analyze mutual funds. You can track an institution’s performance by analyzing their mutual funds. Institutions with better ranking funds are preferable to little-known groups with under-performing funds.
M – Market Direction
Since the techniques are too involved for this article, and I wouldn’t want to steal all the thunder of this stock system, I’ll stick with the simplified version of this one. Basically, the Market Direction is in reference to bull and bear markets. You should only buy when a confirmed bull is in play, and you should sell stocks during bear markets.
How can you tell the difference? The CAN SLIM approach analyzes volume and price bars of widely traded stock market indexes. If too many high volume selling days (distribution days) occur in a short period of time, this may signal that institutions are selling their positions and a bear market is just around the corner.
Conversely, a market bottom can usually be spotted sometime after the third day of a bull rally. On one particular day, the market will surge a couple percent or more with abnormally high volume. This is called a “follow-through day” which is a confirmation that the bull rally attempt has likely succeeded in a new confirmed bull market cycle. The success rate of confirming a bull rally with this technique is reported to be 75%.
So, there you have it, the basics of the CAN SLIM system. In short, you scan for high-growth stocks that are leading the pack, being bought by institutions, have small floats and big volume up-trends, have something “new” about them, and then you buy during a bull market. This approach has generated abnormally high returns compared to the market on average.
But can you isolate exact times to buy stocks with greater precision than what is outlined with CAN SLIM?
The Cup and Handle Buy Signal
O’Neil adds a second, more visual part of his system with chart patterns. In general, he favors what is known as the “cup and handle” pattern, which is a bullish price pattern that resembles a cup with a handle on the chart.
It starts with a U-shaped trading pattern. The stock price goes down, bottoms out, and rises back up. This should be a nice gradual U-shape and not a sharp V-shape where the price spikes down and back up rapidly. After the U-shape trading pattern (which resembles the cup), the stock is almost set to make new highs.
But before a stock can propel to the moon, it needs to shake out some of the nervous shareholders and weak hands. This shakeout occurs as the price pulls back slightly into what is called the handle. Volume dries up on this short-lived price pullback. It is at this point that the stock is ripe for you to invest in before regaining its strength and breaks out to new highs. At either a pivot point, or at new highs, you can buy this stock as it goes into breakout mode.
O’Neil also trades stocks as they break out past their consolidation phases (called bases), or sometimes other patterns known as pennants and flags.
Keep in mind that O’Neil does not simply trade price patterns. He first has a list of top stocks based on the CAN SLIM approach, then trades them when prices form a reliable bullish pattern as they gear for a potential breakout.
The best way to really grasp O’Neil’s technique is to look at a real life example. Follow along to get a better idea of how CAN SLIM can be applied.
Case Study of CAN SLIM
Consider the stock Ebix, Inc (NASDAQ: EBIX) as one potential stock (as of March 2011).
- C – Current Earnings: The last 2 quarters, starting with the most recent, had 42 cents per share (diluted) and 43 cents per share respectively. The same quarters one year earlier had earnings of 31 cents and 25 cents. This translates into quarter over quarter growth of 35% and 72% when looking at the past two quarters of earnings.
- A – Annual Earnings: Between 2008 and 2009 the annual earnings growth per diluted share was 35%. For 2010 it grew to 47%.
- N – New: This company supplies a “new” software and e-commerce product internationally to the insurance industry.
- S – Supply and Demand: Volume for this stock has picked up since 2009 signaling high demand. The float, however, is a little high at 30 million shares, but still close to the recommended 25.
- L – Leader: The 52 week relative strength of this stock is 88%.
- I – Institutional Support: This stock has over 70% ownership by institutions. 128 institutions are holding, which is high, but there are also some big names such as The Vanguard Group.
- M – Market Direction: We are not in a bull market as of the writing of this article (March 2011). Therefore I cannot recommend buying it right now.
Prices recently broke out past a consolidated base of around $25+ per share, but the market is currently holding it down. Though, as I said, I can’t recommend buying stock in this company at this moment, based on CAN SLIM, it is definitely one to keep an eye on.
If you like the lure of fast-moving stocks in bull markets, by all means give CAN SLIM trading a closer look. I’d suggest starting out by investing a small amount of your investment portfolio using the CAN SLIM model. You can then increase that amount as you become more familiar with it.
Keep in mind, even founder William J. O’Neil admits that, while these high-growth stocks are often the fastest climbers in bull markets, they are also among the quickest droppers in bad markets. Therefore, the increase of potential reward requires guts of steel, lightning quick reflexes, and much practice.
Before you jump into this profitable trading style, you would do well to read up on this strategy and some of O’Neil’s more rigid rules for when to sell these stocks if a trade goes wrong. This is a sophisticated model that can experience some significant volatility. As a result, it is best-suited for an experienced investor.
(photo credit: Shutterstock)