Using the method designed by William O'Neil - Investors Business Daily (IBD)
In our previous video looking at Edge & Probability in trading, the following system can be applied to create such an edge. My personal approach differs in regard to it being a Breakout Strategy based on Quality stocks. Nonetheless many use the follow CANSLIM method often accompanied by the Cup & Handle setup to move the odds of success into their favour.
Many great traders have taken inspiration from William O’ Niel, either by directly working with him, through his books, or through numerous communications from his company’s subscription service – Investor's Business Daily, which has since been acquired by News Corp.
William O'Neil has beautifully put in place a trend-following system - CANSLIM, which many traders have picked and tweaked to shape their own trading style. The system is not only helpful in trading but can also be used as an investing tool.
We discuss the basics of CANSLIM in this article by breaking down the components of the strategy and their importance shortly.
I found this performance chart to see how the strategy has performed to date (2022). The top blue line represents the original system and the bottom red line shows the S&P 500 as a benchmark.
Here we have the annualised returns from 2007.
For those who would like to see my previous video on the approach with more technical guidance (Cup & Handle) and book reviews, see the below videos.
– Current Earnings
William O'Neil emphasized deeply on current earnings growth of companies that he traded. This can be gauged by comparing the current quarterly EPS with that of the year-ago quarter. The best candidates to trade had earnings growth at least in excess of 20%, the higher the better. Some traders look for earnings acceleration that is in triple digits..
In the long run, earnings are the sole factor that moves prices. When the companies are seeing surprisingly accelerated earnings growth, that usually converts into accelerated advances in stock prices as well.
This component can easily be incorporated as a part of the filter in the initial screening. Once it’s in place, the screener will only show stocks that have earnings growth higher than the threshold you choose.
Some sectors like biotech and tech start-ups don’t have positive earnings and the markets reward drug approvals, accelerated sales growth, and market share gains among several other traits. In a euphoric market, such stocks see big moves and it can be a mistake to eliminate such stocks from screeners for the lack of earnings. Therefore, it’s always advisable to run a separate screen for such stocks to benefit from such moves.
– Annual Earnings
William O'Neil also emphasized on long-term annual earnings growth of companies. One must select trading candidates which have posted decent annual earnings growth. The long-term average growth should be at least above 10%, the higher the better.
The idea behind looking at annual earnings growth is to ensure that the company has a stable business that has seen a recent change, which is leading to accelerated quarterly earnings growth.
Most stocks that see a rise from multi-year dormancy or years of sub-par returns have a catalyst that drives the earnings for the underlying company. For example, for a biotech stock, it could be a drug approval that can bring in billions in revenue for years to come, or for a consumer technology company, it could be a blockbuster new product.
The new catalyst here could be new products and services, expansion into newer geographies, new regulations or new management.
The key here is to look for catalysts that have long-term implications on the business of the company. Such catalysts tend to change the market participants' perception of the company and lead to big runs and several opportunities to trade.
– Supply and Demand
This component looks for the outstanding stock of shares in the stock you are considering for trading. When limited supply meets huge demand, there is an accelerated advance in price.
Look for stocks that have a low float of outstanding shares and a heavy accumulation of shares (big volume bars with big price moves).
– Leader or Laggard
Always look for stocks that are leaders in leading industries. If you limit your trading to the best of the best, you increase your odds of success significantly.
Leaders have best-in-class earnings growth, great products, and price performance. It doesn’t have to be the largest company in the group. It can be a smaller company that has carved a niche for itself and leading a part of the overall market.
Also important is to look for the leading industry. The industry that the stock belongs to should have a tailwind supporting all the companies in the group. The leader in the pack will be the biggest beneficiary of the tailwind.
– Institutional Sponsorship
Institutional investors like mutual funds, hedge funds, and pension funds are the largest group of investors in the market, controlling three-fourths of the trading activity.
Look for stocks that already have some institutional backing and the catalysts that will force other institutional investors to enter the stock.
It’s big institutional demand that moves the prices and it could be good for traders to trade in sync with the institutional sponsors.
– Market Conditions
Lastly, if everything else is in place and markets are not conducive, three-fourths of your trades will not work. Therefore, trade the largest when the market conditions are in your favour and trade the smallest when the markets are in a downtrend or choppy (when trading long).
'This is something I completely agree with'
Of course, for a short-selling trade, the dynamics change and a downtrend with a lack of, or reversal of, catalyst is the best set-up you can trade.
William O’Neil has suggested a methodology to assess the strength of the market and one can incorporate that methodology for market analysis as a part of the trading routine.
Summing it up
CANSLIM focuses on trading trending markets by selecting leaders that have industry tailwinds, best-in-class earnings performance backed by new catalysts with limited supply, and huge impending demand from institutions.
There are more intricacies in CANSLIM that can be read in O'Neil's bestselling book “How to Make Money in Stocks”, in which he lays down details of each component of CANSLIM and how to go about identifying stocks and entering the trade just at the right time when the stock is about to make its advance. There are also important components of risk management that O’Neil talks about in his book.
This system, like any other, is based on positive expectancy and position sizing. O’Neil suggests concentration in a few stocks and an average winner of at least 2.5x the average loser.
The strategy helped O’Neil average 40% per annum returns for a long time previously and has also helped many other traders post even better performance. CANSLIM is a sensible strategy and if practiced diligently, it can help you build stock-picking and trading skills for a lifetime.
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