Stock-Picking Strategies: CAN SLIM
CAN SLIM is a philosophy of screening, purchasing and selling common stock. Developed by William O'Neil, the co-founder of Investor's Business Daily, it is described in his highly recommended book "How to Make Money in Stocks".
The name may suggest some boring government agency, but this acronym actually stands for a very successful investment strategy. What makes CAN SLIM different is its attention to tangibles such as earnings, as well as intangibles like a company's overall strength and ideas. The best thing about this strategy is that there's evidence that it works: there are countless examples of companies that, over the last half of the 20th century, met CAN SLIM criteria before increasing enormously in price. In this section we explore each of the seven components of the CAN SLIM system.
C = Current Earnings
O'Neil emphasizes the importance of choosing stocks whose earnings per share (EPS) in the most recent quarter have grown on a yearly basis. For example, a company's EPS figures reported in this year's April-June quarter should have grown relative to the EPS figures for that same three-month period one year ago. (If you're unfamiliar with EPS, see Types of EPS.)
How Much Growth?
The percentage of growth a company's EPS should show is somewhat debatable, but the CAN SLIM system suggests no less than 18-20%. O'Neil found that in the period from 1953 to 1993, three-quarters of the 500 top-performing equity securities in the U.S. showed quarterly earnings gains of at least 70% prior to a major price increase. The other one quarter of these securities showed price increases in two quarters after the earnings increases. This suggests that basically all of the high performance stocks showed outstanding quarter-on-quarter growth. Although 18-20% growth is a rule of thumb, the truly spectacular earners usually demonstrate growth of 50% or more.
Earnings Must Be Examined Carefully
The system strongly asserts that investors should know how to recognize low-quality earnings figures - that is, figures that are not accurate representations of company performance. Because companies may attempt to manipulate earnings, the CAN SLIM system maintains that investors must dig deep and look past the superficial numbers companies often put forth as earnings figures (see How to Evaluate the Quality of EPS).
O'Neil says that, once you confirm that a company's earnings are of fairly good quality, it's a good idea to check others in the same industry. Solid earnings growth in the industry confirms the industry is thriving and the company is ready to break out.
A = Annual Earnings
CAN SLIM also acknowledges the importance of annual earnings growth. The system indicates that a company should have shown good annual growth (annual EPS) in each of the last five years.
How Much Annual Earnings Growth?
It's important that the CAN SLIM investor, like the value investor, adopt the mindset that investing is the act of buying a piece of a business, becoming an owner of it. This mindset is the logic behind choosing companies with annual earnings growth within the 25-50% range. As O'Neil puts it, "who wants to own part of an establishment showing no growth"?
O'Neil points to Wal-Mart as an example of a company whose strong annual growth preceded a large run-up in share price. Between 1977 and 1990, Wal-Mart displayed an average annual earnings growth of 43%. The graph below demonstrates how successful Wal-Mart was after its remarkable annual growth.
A Quick Re-Cap
The first two parts of the CAN SLIM system are fairly logical steps employing quantitative analysis. By identifying a company that has demonstrated strong earnings both quarterly and annually, you have a good basis for a solid stock-pick. However, the beauty of the system is that it applies five more criteria to stocks before they are selected.
N = New
O'Neil's third criterion for a good company is that it has recently undergone a change, which is often necessary for a company to become successful. Whether it is a new management team, a new product, a new market, or a new high in stock price, O'Neil found that 95% of the companies he studied had experienced something new.
A perfect example of how newness spawns success can be seen in McDonald's past. With the introduction of its new fast food franchises, it grew over 1100% in four years from 1967 to 1971! And this is just one of many compelling examples of companies that, through doing or acquiring something new, achieved great things and rewarded their shareholders along the way.
New Stock Price Highs
O'Neil discusses how it is human nature to steer away from stocks with new price highs - people often fear that a company at new highs will have to trade down from this level. But O'Neil uses compelling historical data to show that stocks that have just reached new highs often continue on an upward trend to even higher levels.
S = Supply and Demand
The S in CAN SLIM stands for supply and demand, which refers to the laws that govern all market activities. (For further reading on how supply and demand determine price, see our Economics Basics tutorial.)
The analysis of supply and demand in the CAN SLIM method maintains that, all other things being equal, it is easier for a smaller firm, with a smaller number of shares outstanding, to show outstanding gains. The reasoning behind this is that a large cap company requires much more demand than a smaller cap company to demonstrate the same gains.
O'Neil explores this further and explains how the lack of liquidity of large institutional investors restricts them to buying only large-cap, blue chip companies, leaving these large investors at a serious disadvantage that small individual investors can capitalize on. Because of supply and demand, the large transactions that institutional investors make can inadvertently affect share price, especially if the stock's market capitalization is smaller. Because individual investors invest a relatively small amount, they can get in or out of a smaller company without pushing share price in an unfavorable direction.
In his study, O'Neil found that 95% of the companies displaying the largest gains in share price had fewer than 25 million shares outstanding when the gains were realized.
L = Leader or Laggard
In this part of CAN SLIM analysis, distinguishing between market leaders and market laggards is of key importance. In each industry, there are always those that lead, providing great gains to shareholders, and those that lag behind, providing returns that are mediocre at best. The idea is to separate the contenders from the pretenders.
Relative Price StrengthI = Institutional Sponsorship
The relative price strength of a stock can range from 1 to 99, where a rank of 75 means the company, over a given period of time, has outperformed 75% of the stocks in its market group. CAN SLIM requires a stock to have a relative price strength of at least 70. However, O'Neil states that stocks with relative price strength in the 80–90 range are more likely to be the major gainers.
Sympathy and Laggards
Do not let your emotions pick stocks. A company may seem to have the same product and business model as others in its industry, but do not invest in that company simply because it appears cheap or evokes your sympathy. Cheap stocks are cheap for a reason, usually because they are market laggards. You may pay more now for a market leader, but it will be worth it in the end.
CAN SLIM recognizes the importance of companies having some institutional sponsorship. Basically, this criterion is based on the idea that if a company has no institutional sponsorship, all of the thousands of institutional money managers have passed over the company. CAN SLIM suggests that a stock worth investing in has at least three to 10 institutional owners.
However, be wary if a very large portion of the company's stock is owned by institutions. CAN SLIM acknowledges that a company can be institutionally over-owned and, when this happens, it is too late to buy into the company. If a stock has too much institutional ownership, any kind of bad news could spark a spiraling sell-off.
O'Neil also explores all the factors that should be considered when determining whether a company's institutional ownership is of high quality. Even though institutions are labeled "smart money", some are a lot smarter than others.
M = Market Direction
The final CAN SLIM criterion is market direction. When picking stocks, it is important to recognize what kind of a market you are in, whether it is a bear or a bull. Although O'Neil is not a market timer, he argues that if investors don't understand market direction, they may end up investing against the trend and thus compromise gains or even lose significantly.
Daily Prices and Volumes
CAN SLIM maintains that the best way to keep track of market conditions is to watch the daily volumes and movements of the markets. This component of CAN SLIM may require the use of some technical analysis tools, which are designed to help investors/traders discern trends.
Here's a recap of the seven CAN SLIM criteria:
- C = Current quarterly earnings per share - Earnings must be up at least 18-20%.
- A = Annual earnings per share – These figures should show meaningful growth for the last five years.
- N = New things - Buy companies with new products, new management, or significant new changes in industry conditions. Most importantly, buy stocks when they start to hit new price highs. Forget cheap stocks; they are that way for a reason.
- S = Shares outstanding - This should be a small and reasonable number. CAN SLIM investors are not looking for older companies with a large capitalization.
- L = Leaders - Buy market leaders, avoid laggards.
- I = Institutional sponsorship - Buy stocks with at least a few institutional sponsors who have better-than-average recent performance records.
- M = General market - The market will determine whether you win or lose, so learn how to discern the market's overall current direction, and interpret the general market indexes (price and volume changes) and action of the individual market leaders.
Remember, this is only a brief introduction to the CAN SLIM strategy; this overview covers only a fraction of the valuable information in O'Neil's book, "How to Make Money in Stocks". We recommend you read the book to fully understand the underlying concepts of CAN SLIM.
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