The Seven Factors Of Winning Stocks

This week, we are deeply saddened by the death of William J. O’Neil on May 28, 2023, at the age of 90. O’Neil, the founder of Investor’s Business Daily and author of How to Make Money in Stocks, has developed a strategy called CAN SLIM, an acronym to help remember the seven factors that winning stocks tend to possess. In this article I cover AAII’s O’Neil CAN SLIM No Float screening model and give you a list of stocks currently passing our screen based on the approach.

The O’Neil CAN SLIM strategy aims to identify stocks with high historical and projected growth that are likely to have rapid price increases. The strategy includes a market-timing consideration since O’Neil found that investing only during a market uptrend helps to avoid “swimming upstream.” As of May 31, 2023, AAII’s O’Neil CAN SLIM No Float screening model has an annual gain since inception (1997) of 12.2%, versus 5.7% for the S&P 500 index over the same period. The O’Neil CAN SLIM No Float screen is down 3.6% year to date, compared to an increase of 9.8% for the S&P 500 over the same period.

CAN SLIM: The Philosophy

O’Neil was a strong believer in the sustained long-term growth of the American economy due to the freedoms and opportunities available, which he said have made the U.S. a “prime success model” and a leader in high-growth, innovative entrepreneurial companies. The goal of investing in stocks, he believed, is to participate in that long-term growth.

With that basic outlook in mind, O’Neil’s approach starts with the entire universe of stocks—those listed on the major exchanges, including Nasdaq, but favors the stocks of smaller firms, since most innovations and new products come from smaller and medium-sized companies. His system can best be described as a growth stock approach that seeks companies whose stock prices are poised to rise due to favorable fundamental factors within the firm and industry, such as increased earnings due to new products and services, as well as favorable technical factors regarding price trends and the supply and demand for the stock.

In his book, O’Neil says that his approach to investing stems from an analysis covering 40 years of market data, which examined each year’s stocks with the largest percentage price increase to find the common characteristics of the “most successful stocks.” These common characteristics include fundamental factors, inherent in the nature of the firm and industry, and technical factors from observing the price patterns of the stocks.

C = Current Quarterly Earnings Per Share: How Much Is Enough?

The CAN SLIM approach focuses on companies with proven records of earnings growth while still in a stage of earnings acceleration. O’Neil’s study of winning stocks highlights the strong quarterly earnings per share of the securities prior to their significant price run-ups.

When screening for quarterly earnings increases, it is important to compare a quarter to its equivalent quarter last year—i.e., this year’s second quarter compared to last year’s second quarter. Many firms have seasonal earnings patterns, and comparing similar quarters takes this into account.

O’Neil recommends looking for stocks with a minimum increase in quarterly earnings of 18% to 20% over the same quarterly period one year ago. When examining a percentage change, it is not only important to check the figures for unusually small base numbers that may distort the percentage change figures, but it is also important to check if any of the numbers in the calculation are negative. A change in sign, as in a negative to a positive, requires special consideration and may result in misleading screening results. When screening on user-defined fields such as custom growth rates, you may find it useful to include some secondary or qualifying criterion to help ensure proper screening results. In the CAN SLIM screen, positive earnings for the current quarter are required to help make the results of the growth rate calculation more meaningful.

Whenever you are working with earnings, the issue of how to handle extraordinary earnings comes into play. One-time events can distort the actual trend in earnings and make company performance look better or worse than a comparison against a firm without special events. O’Neil recommends excluding these nonrecurring items from the analysis. With our screen, we examine growth in earnings from continuing operations only. The first two screening filters require a quarterly earnings growth rate greater than or equal to 20% and positive earnings per share for the current quarter.

Beyond looking for strong quarterly growth, O’Neil likes to see an increasing rate of growth. An increasing growth rate in quarterly earnings per share is so important in the CAN SLIM system that O’Neil warns shareholders to consider selling holdings of those companies that show a slowing rate of growth two quarters in row. The next screen specifies that the growth rate from the quarter one year ago to the latest quarter be higher than the previous quarter’s increase from its counterpart one year prior. Basically, the current quarter’s growth over the past 12-month period must be better than the previous quarter’s growth over the past 12-month period.

A = Annual Earnings Increases: Look For Meaningful Growth

Winning stocks in O’Neil’s study had a steady and significant record of annual earnings in addition to a strong record of current earnings. The CAN SLIM system tries to identify the strong companies leading the current market cycle.

The primary screen for annual earnings increases that O’Neil uses is for increasing earnings per share in each of the last five years. In applying this screen, we specify that earnings per share from continuing operations be higher for each year when compared against the previous year. To help guard against any recent reversal in trend, a criterion is included requiring that the earnings over the last 12 months be greater than or equal to earnings from the latest fiscal year. This group of criteria proved to be the most stringent independent filter.

N = New Products, New Management, New Highs: Buying At The Right Time

O’Neil feels that a stock needs a catalyst to start a strong price advance. In his study of winning stocks, he found that 95% of the winning stocks had some sort of fundamental spark to push the company ahead of the pack. This catalyst can be a new product or service, a new management team after a period of lackluster performance or even a structural change in a company’s industry, such as new technology. These are qualitative factors that do not lend themselves to easy screening. However, it is possible to study the companies passing the preliminary screens to see if any catalysts exist.

A second consideration that O’Neil emphasizes is that investors should pursue stocks showing strong upward price movements. O’Neil says stocks that seem too high-priced and risky most often go even higher, while stocks that seem cheap often go even lower. Stocks that are making the new high list while accompanied by a big increase in volume might be prospects worth checking. A stock making a new high after undergoing a period of price correction and consolidation is especially interesting. O’Neil feels that decisive investors should have sold a stock long before it hits the new low list.

S = Supply And Demand: Small Capitalization Plus Volume Demand

As the catalyst starts pushing the price of a company’s stock up, those firms with a smaller number of shares outstanding should increase more quickly than those with many outstanding shares. In his study of winning stocks, O’Neil found that 95% of the winning stocks had fewer than 25 million shares outstanding, while the median for the group was 4.6 million shares.

O’Neil suggests that investors consider looking at the actual “float” of the stock. The float is the number of shares in the hands of the public—determined by subtracting the number of shares held by management from the number of shares outstanding. In the original CAN SLIM screen, we limited the float to 20 million shares. As companies have become larger, this float has become increasingly restrictive. In addition, O’Neil did not explicitly lay out this requirement in his original book. The CAN SLIM No Float approach does not state a specific float requirement.

L = Leader Or Laggard: Which Is Your Stock?

O’Neil is not like the patient value investor—looking for out-of-favor companies and willing to wait for the market to come around to his viewpoint. Rather, he prefers to scan for rapidly growing companies that are market leaders in rapidly expanding industries. O’Neil advocates buying among the best two or three stocks in a group. You should be compensated for any premium you pay for these leaders with significantly higher rates of return.

O’Neil suggests using relative strength to identify market leaders. Relative strength compares the performance of a stock relative to the market. Relative strength is typically reported with a base level of zero or one—in which case the base level represents stock performance equal to the market index. Numbers above the base level reflect performance above the market index, while below-market performance can be seen with figures below the base.

Companies are often ranked by their relative strength performance and their percentage ranking among all stocks is calculated to show the relative position against other securities. IBD presents the percentage ranking of stocks, and O’Neil recommends only looking for stocks with a percentage rank of 70% or better—stocks that have performed better than 70% of all stocks. If you wish to make the market leader screen more stringent, O’Neil suggests only considering stocks that have relative strength rankings of 80% or 90% with a chart base pattern.

When monitoring your portfolio, O’Neil recommends that you sell off your worst-performing stocks and keep your best-performing stocks a little longer. You should try to avoid letting your ego dictate your actions. It is best to recognize a mistake early, before it becomes a major problem.

I = Institutional Sponsorship: A Little Goes A Long Way

O’Neil warns against selecting low-priced stocks with small capitalization and no institutional ownership, because these stocks have poor liquidity and often carry a lower-grade rating. O’Neil feels that a stock needs a few institutional sponsors for it to show above-market performance. Three to 10 institutional owners are suggested as a reasonable minimum number. This number refers to actual institutional owners of the common stock, not institutional analysts tracking and providing earnings estimates on stocks. Beyond looking for a minimum number of institutional owners, O’Neil suggests that investors look at the past record of the institutions. The analysis of the holdings of successful mutual funds represents a good resource for the investor because of the widely distributed information on mutual funds. We established a screen for stocks to have at least five institutional owners.

It is difficult to strike a balance between looking for stocks with room to expand further and stocks that may be over-owned. O’Neil warns that while some institutional sponsorship is required, once everyone has jumped on the stock, it may be too late to buy into it.

M = Market Direction: How To Determine It

The final aspect of the CAN SLIM system looks at the overall market direction. While it does not impact the selection of specific stocks, the trend of the overall market has a tremendous impact on the performance of your portfolio. O’Neil focuses on technical measures when determining the overall direction of the marketplace. Any good technical program or even a study of IBD or The Wall Street Journal should provide you with the necessary tools to study market movement.

O’Neil finds it difficult to fight the trend, so it is important to determine if you are in a bull or bear market. If you are selecting your own stocks, it is important to follow and understand what the general market averages are doing every day. When the market peaks and begins a major reversal, O’Neil recommends that you try to put 25% of your portfolio into cash. It is important that you act quickly, especially if you have purchased your stocks on margin.

Other items to look for at a market top include heavy volume without significant price progress and the divergence of key averages. At market tops you often find stocks that were past market leaders faltering, while poor-quality stocks are showing up on the most active lists. When the market starts down, it sometimes takes time for the volume to build. O’Neil warns that the market can be slow to acknowledge the downtrend.

Conclusion

The CAN SLIM system has great appeal to the active investor looking for growth stocks. While the approach is specific, it also stresses the art of investing when analyzing companies highlighted by the approach and interpreting the direction of the market.

Companies Passing the O’Neil CAN SLIM No Float Screen (Ranked by 52-Week Relative Strength)

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The stocks meeting the criteria of the approach do not represent a “recommended” or “buy” list. It is important to perform due diligence.

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