Growth Investing

Growth investors refuse to join the bargain hunting bandwagon, choosing instead to identify young, disruptive companies offering innovative products and services with massive profit potential. Typically, these firms have already accelerated their profitability for years before starting a prolonged phase of profitability and share price growth, and their stocks usually break out of a plateau and reach all-time highs before beginning their big climbs. This allows investors to identify these firms early enough to make exceptional returns.

The best growth stocks tend to be young, small, and cheap. But they can also appear absurdly overvalued before making their big moves. Many valuation metrics often use past data and assume a company’s earnings will continue to grow at its historical rate, an invalid assumption for growth companies that frequently generate earnings growth that’s double, triple, or even ten times the historical rate. Valuation ratios that use estimates of future earnings are also highly misleading, since analysts often severely underestimate these maverick companies’ success. As long as these firms beat expectations, their stock prices typically continue climbing no matter how excessive their valuation metrics appear.

William O’Neil’s CANSLIM Strategy

William O’Neil popularized his own approach to growth investing in his classic investing book "How to Make Money in Stocks" (2004). He studied the best performing stocks in every bull market between 1880 and 2009 and found that they all shared several characteristics composing the acronym CANSLIM:

● Current quarterly earnings and sales per share are accelerating

● Annual earnings are accelerating over the past several years

● New products, management, or other catalyst is pushing the stock near a new high

● Supply of shares is small and decreasing

● Leading the pack; the stock should be one of the industry’s top three best performers

● Institutions with strong performance records are buying shares

● Market as a whole is in a strong uptrend or bottoming out and reversing after a prolonged downtrend

After verifying that the stock’s fundamentals and the general market’s direction both satisfy CANSLIM, O’Neil suggests that investors analyze the stock’s prior price movements. He insists that investors only buy stocks breaking out of certain types of price patterns. First, let’s learn O’Neil’s fundamental criteria.

C: Current quarterly earnings and sales per share are accelerating

A company’s current quarterly earnings per share should be at least 20% higher than the same quarter’s earnings per share last year. This apples-to-apples comparison ensures investors aren’t fooled by firms with seasonal profitability, such as a clothing store that usually reports stronger earnings in Q4 than Q3. O’Neil himself prefers a higher minimum year-over-year (YoY) EPS growth of around 40%. His research found that from 1953 through 1993, 75% of the best performing stocks saw YoY quarterly EPS growth near 70% before starting their big moves. Some stellar growth stocks will show earnings growth of more than 500%; this is rare and highly positive, but be sure to verify that the growth isn’t due to a tiny earnings per share in the same quarter last year, like one or two cents.

The current quarter’s YoY EPS growth should be drastically higher than in previous quarters. For instance, it’s great if a company’s YoY quarterly EPS growth went from 25% last quarter to 40% this quarter, while the reverse could signal weakness. Investors should keep a logarithmic-scale chart of a company’s total earnings over the most recent four quarters and update it quarterly. This rolling 12-month earnings plot should be close to or at a new high. If you’re betting on a stock recovering from falling earnings, you can consider investing in it after one quarter of earnings improvement if that quarter makes the rolling 12-month earnings plot rise dramatically and reach an impressive new high.

The company should also see YoY quarterly sales growth of at least 25%, proving that the earnings growth comes from sales rather than accounting tricks or cost cutting. Avoid companies with strong sales growth but weak earnings growth; they’re likely struggling with reducing costs and maintaining profit margins. To further boost your performance, require that a company’s most recent quarter’s after-tax profit margin is at or near a new high and is one of the best in its industry.

O’Neil urges investors to read the company’s earnings report and ensure that the strong profits aren’t due to a one-time transaction like the sale of a production plant. Investors should also check that the company’s industry has at least one other noteworthy stock with similarly strong quarterly earnings, indicating that the company’s success isn’t a fluke. It’s also a good idea to look at the next couple quarters and make sure the company isn’t entering a quarter that saw unusually strong YoY quarterly earnings growth in the prior year. This check increases the odds that the company will deliver earnings surprises in the upcoming quarters.

Avoid companies with two consecutive quarters of declining YoY EPS growth rates, even if each rate is above the minimum criteria, as these companies may be entering hard times. Also, avoid firms that release their quarterly earnings several weeks after their expected report date; they may be taking time to fudge the numbers. Watch out if a stock shows weak price action compared to its industry group or the general market in the month prior to its earnings release. This indicates that the market anticipates a weak earnings report.

A: Annual earnings are accelerating over the past several years

A company’s annual earnings should have increased at least 20% every year over the past three to five years. O’Neil stresses that the 20% threshold is just a minimum; truly stellar stocks see annual earnings growth closer to 50 or even 100%. Investors should also analyze earnings stability and prefer stocks with the most consistent earnings growth. They can do this by plotting the quarterly earnings over the past three years on a logarithmic-scale chart and drawing the trendline. Ideally, the earnings should closely resemble a straight, upward-sloping line and show only minor deviations from the trend line. If a stock is less than three years old, investors should require that it has big earnings and sales growth over the past five or six quarters before considering to buy.

O’Neil also recommends requiring a stock to have a high return on equity (ROE), which is a company’s net income divided by its shareholders’ equity. The metric measures how well a company used the funds that it raised by selling shares to investors. He suggests requiring a ROE of at least 17%. His research found that during the half century ending in 2009, the vast majority of the best growth stocks had a high ROE. He also recommends requiring that next year’s earnings estimate be up significantly from the current year’s. But keep in mind that analysts’ predictions have a spotty track record.

N: New product, management, or other catalyst is pushing the stock near a new high

O’Neil’s research found that from 1953 to 1993, 95% of companies with the best stock price performance had a key catalyst before their big advances: new products/services, new management, or a significant industry-wide development such as a resource shortage or drastic technological improvement. He also found that those stocks reached new highs before their stunning advances. Take Cisco, which offered innovative devices that allowed companies to connect their widely-dispersed computer networks. It made a new high in November 1990 before rising 75,000% by 2000. During the intermediate term, stocks making new highs are statistically more likely to continue their advances than reverse. This “momentum effect” has overwhelming empirical evidence, and researchers consider it one of the major predictors of price movements.

S: Supply of shares is small and decreasing

Ultimately, a stock’s supply and demand drive its price movements. O’Neil recommends investors look for stocks with a small and decreasing supply of shares. They should prefer stocks with fewer outstanding shares, smaller market capitalizations, and low floating supplies, aka “floats”. The float is the number of shares that the public can own, which equals the total number of outstanding shares minus the number of shares that are closely held by insiders. Investors should favor companies with a high percentage of shares owned by company insiders, preferably 1-3%, because insiders who own stock are financially incentivized to run the companies well. Be aware that small caps are less liquid and more volatile than larger companies. Luckily, investors have many ways to reduce their risk, which we discuss later.

Investors should also look for companies whose insiders are buying back their stocks. This is another strong indicator of management’s optimistism. Stocks should also show strong trading volume on up days and weak volume on down days, suggesting that large institutions are repeatedly buying large quantities and are in no hurry to unload. Investors should also prefer stocks with a low and falling debt-to-equity ratio, which compares a company’s debt to its market cap. Companies with a high debt ratio are debt-laden and likely to struggle during economic turmoil and periods with high loan rates. Avoid stocks with share splits; some 80% of the best performing stocks have never had one, and stocks often top out after the second or third one.

L: Leading - one of its industry’s top two or three stocks with the best price performance

O’Neil suggests that investors require a stock to be in its industry’s top two or three best performers and show impressive performance relative to the general market. To see if a stock is a leader, divide its stock price by the S&P 500 or total stock market index and plot it over time. This is the relative strength (RS) line. Investors should compare a stock’s RS line with the RS lines of its industry peers. A stock’s RS line should be one of the most impressive in its industry. It should be increasing and reaching new highs, or reversing from a downtrend by breaking out of a plateau. During market declines, the best stocks usually decline between 1.5 to 2.5 times as much as the general market averages. The shallower the drop, the better. Then, after the market downturn ends, the best stocks tend to be the first to hit new highs. Most of these leaders will be unfamiliar names. The prior bull market’s leaders rarely lead the next.

I: Institutions with strong performance records are buying shares

O’Neil recommends that investors require that stocks have an increasing number of high-quality institutional sponsorship. Investors should generate a list of the best-performing institutional investors and track how many of them have invested in the stock. That number should be at least 20 and should be increasing over the past couple quarters. This ensures that the “smart money” agrees that the stock is worth buying. Investors can identify the best-performing institutions by considering both their 12-month and 36-month performance.

Additionally, investors should take special note when a high-quality institutional investor opens a new position in the stock in the most recent quarter. This is more important than the overall ownership trend. After opening a new position, institutions usually continue adding to that position over time and are less likely to exit. This can cause long-term price increases. These large financial institutions also provide liquidity, so if you urgently need to sell you will likely find a buyer. Sadly, funds usually disclose their positions six weeks after the end of their quarter. But despite the delay, this information still has value. Remember, institutions tend to build their stock positions over years.

A lack of institutional sponsorship suggests most successful banks and investment firms have analyzed the stock and decided not to buy. The price won’t move if these players aren’t interested. O’Neil approximates that around 80-90% of a stock’s important price movements result from institutional transactions. But be weary of overowned stocks. The goal is to jump in before all the smart money is already invested. That way, you can profit from the price increases that occur as other institutions become interested in the stock and buy, bidding up the price. Stocks with a thousand institutional sponsors or more are too popular, and more likely to see massive waves of selling when the company disappoints or the general market starts turning down.

M: Market is already uptrending or reversing after a prolonged downtrend:

Stock Market Cycles

Stocks alternate between long uptrends, called bull markets, and shorter and more violent downtrends, called bear markets. Since 75% of stocks increase in bull markets and 75% decrease in bear markets, O’Neil urges investors to maximize their chances by only buying stocks when a bull market is just starting or is already underway. The best opportunities usually occur in the first two years. Later in a bull market, most stocks have already had stunning advances, and breakouts have a lower success rate as institutions start selling to unwind their positions. Thus, identifying market tops and bottoms is crucial.

The stock market is a leading economic indicator. Why? Investors move prices by buying and selling based on their expectations of future business conditions, and they tend to be right. That’s why bull markets often start while business conditions are still falling and end while conditions are still improving. Most current economic data describes the present, not the future, so it likely won’t help you forecast the market.

As expected, though they may be able to analyze the present, economists fail to predict the future; they often under-anticipate it and assume that the present trend will continue. These “dismal scientists” have a dismal track record, failing to predict 148 of the past 150 recessions and the majority of past booms that occurred around the world from 1992 to 2014. Hence, O’Neil says investors must track the markets themselves to identify their turning points. He suggests watching the S&P 500, NYSE Composite, Dow, and Nasdaq Indexes daily.

During bull markets, market indexes usually start the day weak and finish strong, while the opposite is true for bear markets. Bull markets have short-term dips, or corrections, around 8-12% on average. Meanwhile, most investors define bear markets as a drop in a market index of at least 20%. Generally, bull and bear markets typically end after two to three fakeouts.

Identifying Tops

To identify a short or long-term market top, investors should look for days when a market index has a higher trading volume and smaller price increase than the day prior. These “distribution days” result from large institutional selling. If the market has a down day with higher volume than the prior day, it must fall at least .2% to be a true distribution day. These days also tend to have a wider spread between the daily high and low, though this isn’t a requirement.

The market usually peaks after having four or five distribution days over a span of four or five weeks. Distribution sometimes occurs over a six week period if the market index pauses its distribution and attempts to rally toward a new high before resuming. When any one of the indexes show this excessive distribution, a top is likely at hand. These distribution days sometimes occur while the market is uptrending, explaining why many investors miss market tops. Generally, these tops occur 5-7 months following the most recent breakout in CANSLIM stocks and market indexes. Many occur 3-9 days after market indexes have rallied into fresh highs but from excessively short-term chart bases.

When you spot a top, you should protect your portfolio by selling at least 25% of your portfolio to raise cash and returning any borrowed funds. Use market orders to exit as quickly as possible. Fighting for a couple pennies per share isn’t worth waiting for your transaction to fill while the stock is plummeting in the meantime. Experienced investors with a high risk tolerance may consider short-selling. Funny enough, the best-performing CANSLIM growth stocks make the best shorts; they reach heavenly valuations before crashing the hardest. But shorting is perilous and requires precise timing. Few investors survive it, let alone profit from it.

After experiencing distribution, the market index will either rally weakly and fail or strongly and succeed. Weak rallies occur when the market index gains less than half of the initial drop from its former absolute intraday high, the market index advances less than it did the prior day, or the market index rises on the third, fourth, or fifth day of the rally with lighter volume than the day before. Once the rally fails, investors should sell even more of their holdings.

During the first rally attempt after the market falls from its highest peak, you may want to watch the market indexes and their volumes on an hourly basis if you have the time. This helps you assess the rally’s strength; the rally is weak if volume is falling while the index is rising, or if the rally starts to decelerate or reverse as volume increases. Hourly analysis also helps when the market is breaking below a previous low; it’s a good sign if volume falls or only rises slightly when this occurs. If this is the case, O’Neil suggests next looking for a day where volume is significantly lighter than usual, or looking for a couple days of heavier volume while the market stays flat or rises. This indicates that the market may bounce back.

O’Neil offers other tools to confirm the end of bull markets. Capital goods industries like railroads and machinery tend to perform strongly near the end of the market cycle. Near the bull market’s end, opportunities are few, and your last few CANSLIM purchases have likely failed. Also, cheap, low-quality laggard stocks often outperform at the end of bull markets; on days when the market is up, its most-active stocks mostly consist of laggards.

The leading stocks usually start to misbehave several days or even weeks before the market shows signs of distribution. Their breakouts become volatile and faulty, and many experience decelerating quarterly earnings growth. Several will have the “climax top” sell signal, an exponential price increase in the past two weeks after months of an impressive advance. Later we’ll learn about them in more detail. Don’t expect all leading stocks to falter as the market tops. Several will continue their advances and report strong earnings. But eventually their prices will fall along with the rest of the market despite their healthy fundamentals.

Market indexes often start to diverge near the bull market's end. Watch out if one index reaches a new high while others do not. Often, a concentrated index like the Dow will reach new highs while the broader S&P 500 and the Nasdaq don't. O'Neil says this occurs because institutions are trying to discreetly exit most of their positions. They hope to distract investors from the declining broad indexes by artificially bidding up the more concentrated Dow index. Also be weary when some indexes increase a much lower percentage than others.

Identifying Bottoms

O’Neil observed that bear markets often have three main down movements separated by temporary rallies that lure investors back in too early. These fake-outs result from big institutions buying cheap stocks that have supposedly bottomed. Since they have long time horizons, institutions don’t mind buying low-priced stocks even if the overall market will continue to fall. This “bottom-fishing” creates flawed rallies that last at most 15 weeks before failing.

After first seeing a rally, investors should wait for the market’s price action to verify that the downtrend is ending.

A market average is attempting a rally if it ends the day higher despite falling earlier in the day or during the prior day. Once the rally starts, you usually can't evaluate its strength until the fourth day. Then, start looking for a strong follow-through day, where one of the indexes rises at least 1.5% and with higher volume than the previous day. You may want to require a higher percent increase for the Dow and Nasdaq. Those indexes are more concentrated, containing 30 and 100 stocks respectively, so just a few large institutional transactions can more easily move them.

Follow-through days often have a volume that exceeds the average daily volume over some time period, usually 90 days. They usually occur 4-7 days after the rally first begins. Sometimes they occur after only three days; if so you should require that all three of those days gained at least 1.5% on heavier volume than the prior day and the average. Once you identify follow-through, you can start looking to buy CANSLIM stocks if they break out of one of O'Neil's preferred types of price formations.

Sometimes, even rallies that have apparently sufficient follow-through still fail. This typically occurs after a faulty follow-through that was generated by just a handful of big institutions who had enough buying power to create the appearance of a broad market advance. These false signals often fail sharply and on heavy volume in the next couple days. Sadly they are impossible to identify until after the fact.

On the other hand, don't fret just because the market drops on the day following the follow-through. Bear markets rarely end cleanly. The reversal may still be legitimate. It's a good sign if the market index stays above its lows from the last couple weeks and above its recent intraday lows.

Secondary Indicators

Bull markets often end when investor sentiment reaches extreme optimism, and vice-versa for bear markets. O’Neil recommends gauging that sentiment by looking at the put/call (P/C) ratio, which compares investors’ demand for put and call option contracts. These contracts allow investors to profit from stock price movements as though they were buying or shorting dozens of shares, but at a fraction of the cost. They are only valid for a limited amount of time and often expire worthless if the stock doesn’t move enough. Investors use put options, aka puts, to bet on a stock falling and call options, aka calls, to bet on it rising. Sadly, novice investors try to use options to get rich quick and are often wrong. Hence, investors can see how option traders are betting and view it as a contrarian indicator. The higher the P/C ratio is, the more investors who are bearish and betting on a price drop by buying puts.

Many investors look at the Chicago Board Options Exchange’s (CBOE) total P/C ratio, which considers options on stocks as well as market indexes to give a snapshot of overall market sentiment. You can focus on professional investor sentiment by looking at the P/C ratio of just the index options market. Most index options are used by institutions and professional money managers for hedging or other advanced strategies. Meanwhile, the P/C ratio for just equity options reflects amateur and retail traders’ sentiment. Historically, CBOE total P/C values at or above 1.2 indicate excessive bearishness, and vice-versa for values at or below 0.7.

O’Neil mentions another contrarian sentiment indicator: the percentage of bearish investment advisors. Most advisory services are bearish when the market is near a bottom, and vice-versa for tops. You probably won’t see the exact same percentage of bearish investment advisors at every market top or bottom, but indicators like this still give you an overall sense of whether sentiment is reaching extreme levels.

You can also measure bearish sentiment by tracking short sellers’ activity. The NYSE short-interest ratio measures the amount of short-selling volume compared to overall trading volume for the NYSE. To help identify market bottoms, O’Neil recommends studying this ratio’s behavior at previous bottoms and comparing it to its recent behavior.

Investors can look at the advance-decline (A-D) line to evaluate the strength of rallies during an obvious bear market. Every day, the A-D line plots the ratio of stocks that are advancing compared to the ones that are falling. During a bear market, if the A-D line sinks while the market rallies, the downtrend is likely to continue. But O’Neil doesn’t recommend using the A-D line to spot tops. It can peak years before the market does, prompting investors to prematurely exit and miss some incredible gains. Investors are better off focusing on how the leading stocks are behaving.

You can use the upside/downside ratio to help identify shorter-term turning points. It compares the trading volume of rising stocks and falling stocks. To smooth out this choppy indicator, investors often graph its 10-week moving average. After a market correction (10-12% drop), this indicator may diverge and rise while the market continues to fall. If so, the market is likely to have a short-term advance in the near future.

Analyzing defensive stocks can help you avoid jumping in too early. These companies have more consistent earnings and dividends and typically fall less than the rest of the market. Some examples include utilities, soaps, food, and tobacco companies. O’Neil observes that many analysts mistakenly expect a bear market to end just because a high portion of stocks are making new highs. However, if the majority of stocks making new highs are defensive, the bear market is actually likely to continue. Also, before the market tops or corrects, supposedly “smart money” will sometimes pile into defensive stocks and/or gold, but not always; this indicator has a spotty track record.

Nasdaq stocks tend to be more speculative and risky than NYSE stocks. That’s why investors used to compare Nasdaq and NYSE trading volume to measure investor optimism. But as more and more entrepreneurial tech companies are joining the Nasdaq exchange, Nasdaq trading volume is increasing over the long-term. It now exceeds NYSE volume, making this indicator difficult to use.

Lastly, O’Neil recommends investors watch the loan interest rates set by the Federal Reserve, the central bank of the United States. The Fed alters credit affordability when it wants to accelerate or decelerate economic activity. O’Neil suggests investors watch the Fed funds and discount rates to get a feel for the current economic environment. Often, bear markets and recessions begin after the Fed increases one of these key rates three times in a row, and bear markets often end when the Fed finally stops increasing these rates. But don’t expect this to always happen; these conditions just make market turns more likely. Several bear markets have begun without three successive rate hikes, and several bear markets have ended well before the Fed stopped hiking rates.

Remember that these are secondary indicators; their presence increases the odds of a market reversal. But don’t require these conditions before believing that the market has topped or bottomed. Focus on the price action of the market indexes themselves, as well as the leading stocks within.

Price Action Criteria

After verifying that the stock’s fundamentals and the general market’s direction both satisfy CANSLIM, O’Neil suggests that investors analyze the stock’s prior price movements. His studies indicate that after breaking out, the best stocks tend to move up 20% to 25% and then plateau and build a new base before resuming their uptrend. He recommends investors only buy stocks breaking out of a base. O’Neil drew heavy inspiration from Jesse Livermore, a famous trader who noticed that the best growth stocks tend to alternate between uptrends and plateaus that look like shallow boxes. Livermore recommended buying stocks when they break out of the box’s upper bound (see below). O’Neil offers more detail, identifying eight different types of price patterns and discussing the ideal buy points for each.

Whichever pattern you use, be sure to look at it using log-scale charts. Otherwise, a move from 40$ to 50$ looks as impressive as a move from 10$ to 20$, even though the former is a 25% gain while the latter is a 100% gain.

Once you buy at the ideal buy point, watch the stock and cut your losses if it falls more than seven to eight percent. His research shows that breakout stocks rarely fall by more than that amount and succeed. Investors are better off exiting while the loss is manageable and looking for other opportunities with better odds.

Many traders mistakenly feel the loss isn’t real until they sell. But as O’Neil explains, if your account shows a loss, it’s already real. Selling doesn’t force the loss to materialize; it frees you from a trade that failed and is unlikely to succeed so you can put your funds in more promising opportunities. Sometimes, bad overnight news causes stocks to gap down and open at a price below your loss-cutting threshold. As painful as this is, it’s crucial that you exit and cut your losses before they get even worse.

If you miss the breakout day, you can buy later, but only if the stock hasn’t risen more than 5% beyond the ideal buy point. Otherwise, you are entering when the stock is extended and likely to pullback. Healthy pullbacks don’t fall more than 7% below the ideal buy point. But if you buy when the stock is 5% or more extended from that point, that healthy pullback exposes you to losses of at least 12%. This is harder to come back from than a 7% loss. Your loss-cutting rules will rightfully force you to exit before that natural pullback reaches completion, and you’ll miss out on a healthy breakout.

Cup with Handle

O’Neil claims this is both the most common and important chart pattern. As the diagram below shows, it contains three parts: the prior uptrend, the cup, and the handle. Stocks can also break out of cups without handles, but those breakouts have a lower success rate.

In brief, cup with handles should have the following characteristics:

● Prior uptrend of at least 30%

● Cup at least 7 weeks long and 12-33% deep

● Light volume near the cup’s lows, and several “tight” weeks during the cup

● Handle at least 2 weeks long

● Etc Etc Etc

The prior uptrend should be at least 30%, show. During its uptrend, the stock should be showing increasing relative strength against the general market and should have several instances of substantially above-average volume, which indicates that institutions are buying. These conditions show that other investors have noticed the same stock you did. Even the most exciting and profitable companies don’t make good investments unless other investors are interested and willing to bid up its price.

As for the cup, in almost all cases, it should be u-shaped rather than v-shaped. Why? The u-shaped base prolongs the period of time that the stock falls. The more time the stock spends slumping, the greater the odds that skeptical shareholders will unload. The remaining shareholders will be the optimists who want to stay the course and make more purchases over the long term, which will allow the stock to make a powerful advance. But if the stock’s drop is quick and v-shaped, many of the skeptical shareholders won’t yet sell. Sometime in the future, they will exit, flooding the market with sell orders and impeding the stock’s advance. It’s better that these skeptics exit earlier. When they later see their mistake, they’ll eventually reinvest and push the price even higher.

O’Neil’s research found that the best stocks’ cups tended to be 7-65 weeks long and had a depth between 12 and 33% when measured from the cup’s first peak. A “saucer” is like a cup but shallower and spans multiple years; O’Neil believes saucers are another profitable chart pattern.

Cups typically occur during general market corrections and are often 1.5 to 2.5 times as deep as the general market’s correction. That’s because young, entrepreneurial companies are generally riskier and more volatile than the overall market. However, the shallower the cup is compared to the rest of the market the better. This indicates that despite the selling from skeptical shareholders, other investors are still interested and willing to buy. The greater their interest, the more they buy and resist the selling from skeptical shareholders, resulting in a shallower price decrease.

If the cup formed during a bear market or serious decline and the market has recently resumed its uptrend, you can allow the cup to be deeper than 33%. But be sure to compare its depth to the depth of the market drop during that same time period. Again, focus on stocks that corrected no more than 2.5 times as deep as the market; the shallower the better.

When you view the stock’s weekly chart, the cup should contain several weeks with tight price action, meaning a small spread between the week’s high and low. If all trading weeks in the base have wide spreads, the stock is already well-known and heavily traded. This is what causes such severe intraweek price swings. Plus, well-known stocks are more likely to be fully appreciated by other investors. If everyone is already on board, who is left to buy and push up the price? Hence, O’Neil is only interested in stocks that most of the market hasn’t yet discovered.

Near the cup’s low, the volume of one or two trading weeks should be quite light. This indicates that most of the shareholders who were considering selling have already done so, and very few potential sellers remain. Whatever shareholders remain likely want to hang on for the long haul and see how well the company performs. During the cup, strong stocks should have a greater number of up weeks with above-average volume than down weeks with above-average volume. This suggests that the market is more interested in buying the stock than selling it.

The best stocks’ typical handle areas are usually at least one to two weeks long. They often form in the cup’s top half when measured from the cup’s initial peak. During the handle, the stock price should downtrend rather than stay flat or inch upwards. O’Neil claims this helps motivate skeptical shareholders to exit their positions. Avoid handles that can’t stay above the stock’s 50-day, or 10-week, moving average. This indicates that the market’s excitement and buying interest is enough to keep price from falling excessively as skeptical shareholders unload. The healthiest handles usually drop between 8 and 12% from the start of the handle. You can allow handles to fall between 20 and 30% if they occurred during the last downleg of a bear market and the market is beginning a new uptrend.

O’Neil’s research found that the ideal buy point occurs when price breaks above the initial peak of the handle, which he calls the “pivot point.” When this occurs, volume should be at least 40% higher than average; the higher the better. These volume surges result from big institutions opening positions in the stock. The pivot point usually occurs between 5 and 10% below the prior peak in the vast majority of instances. O’Neil says that if you wait for a new high, the breakout may be almost out of gas. It’s better to buy at the exact pivot point.

To get in a bit earlier, you can draw a downward-sloping line that connects the cup’s initial peak with its later peak, which is where the handle starts. When the price is still in the handle, extend that line and buy when the stock breaks above it. For this to succeed, O’Neil stresses that your chart analysis must be precise.

The rest of O’Neil’s preferred chart patterns share many of the same characteristics as the cup with handle pattern: prior uptrend with several instances of heavy buying, more up weeks with above-average volume than down weeks with above-average volume during the base, and lighter volume near the pattern’s lows. The other patterns just have different geometric parameters, briefly summarized below. Regardless of the shape, the day of the breakout should have volume at least 40% above the average.

Double Bottom

This base is w-shaped, sometimes with a handle and sometimes without it. If it has a handle, the ideal buy point occurs when price breaks above the handle’s initial high. Without the handle, the ideal buy point occurs when price breaks above the middle peak of the “w.” Make sure the pattern’s second low is equal to or below the first low. Its handle and/or base criteria regarding depth and length mirror those for the cup with handle.

Flat Base

This base commonly forms after the stock breaks out from a double bottom or cup/saucer with handle and rises about 20%. After that rise, the stock often flatlines, travelling horizontally for at least 5 weeks and correcting less than 15%. The ideal buy point occurs when the stock surpasses the high of its flatlining phase. You can allow a shorter minimum base length of 4 weeks if the stock has risen 15% before flatlining rather than 20%.

High, Tight Flag

O’Neil says this uncommon pattern has high profit potential. They’re similar to flat bases, but have a prior uptrend of at least 100%, a minimum length of three weeks, and a maximum correction depth of 10%.

Ascending Bases

Like the flat base, this pattern commonly forms after the stock breaks out from a double bottom or cup/saucer with handle and rises about 20%. After that rise, the general market starts to correct choppily; the stock drops three times, each shallower than the last and no more than 20%. The pattern’s ideal buy point occurs when the stock breaks above the pattern’s high.

Base on Base

This pattern happens when the general market starts downtrending just after the stock breaks out of a base. Instead of rising the expected 20% beyond its ideal buy point, the stock corrects along with the general market and forms another base just above the prior one. O’Neil says investors should buy if the stock surpasses that newer base’s ideal buy point, which varies depending on the base type as previously discussed.

Other Selection Considerations

Wash-over Effect

As O’Neil explains, when one of the biggest and most successful companies in a particular industry starts slumping, institutional investors may jump ship and exit the entire industry and cause the rest of its stocks. Those other stocks often suffer in spite of their impressive earnings growth and their recent price increases into new highs. You can spot this happening by looking at the relative strength of the other stocks in the industry compared to the general market. It often sinks before those stocks start falling heavily. While this is occurring, analysts fail to consider this effect and remain strongly optimistic on the fundamentally strong stocks in the industry. That mistake is a costly one.

Follow-on Effect

Some industry and consumer trends can cause predictable chain reactions that benefit particular industries. O’Neil offers many examples. The rising popularity of air travel in the ‘60s later boosted the profits and share prices of hotel companies. Severe oil price increases in the ‘70s drove an upward move in the stocks of companies that drill for oil or supply drilling-related equipment and services. This is similar to O’Neil’s “supplier stock” concept. Often, one industry’s boom fuels the boom of the industry that supplies it. The boom in airline demand drove the boom in the stocks of companies that supplied airplane equipment, especially chemical toilets.

Commentary: Evidence, Merits, and Drawbacks

O’Neil’s stock picking philosophy makes intuitive sense. Young, small companies with innovative products/services and impressive earnings and sales growth are likely to continue their success streaks. Their impressive past profitability proves that they’ve identified a product/service with a strong and increasing demand from consumers. This increases the odds that they can gain market share from competitors. As they grow and gain that market share, their profits and thus share prices will continue to rise. O’Neil offers many clearly-defined rules that help investors adhere to his approach, and he provides solid risk management advice: sell once the trade goes south and conditions no longer justify expecting strong stock performance. Exit while the loss is manageable so you can put your funds in more promising opportunities.

O’Neil built his criteria based on history’s best-performing stocks. This technique is known as reverse factor modeling. He claims that his research shows that these great stocks have a strong probability of satisfying CANSLIM criteria. But he doesn’t address what portion of CANSLIM stocks go on to become the best performers. For instance, even if 100% of the best performers satisfied CANSLIM criteria before their big runs, it’s possible that these winners represent just a small slice of all of the stocks that satisfied CANSLIM criteria. If this were the case, CANSLIM criteria would only be useful as an initial screen.

Seemingly intuitive strategies aren’t always profitable. O’Neil provides thin empirical evidence of his strategy’s success. He references research from the American Association of Individual Investors, which found that from 2002 to 2017 the CANSLIM approach earned a 21.8% annualized return compared to the S&P 500’s 4.2% annualized return during the same period. But that study didn’t compare the strategy’s risk-adjusted performance compared to the general market’s.

Yet that comparison would be the best test of the strategy’s validity. The CANSLIM strategy’s higher returns may have come with heavier drawdowns. If those drawdowns are intense enough, the strategy’s overall reward/risk ratio may not exceed the market’s. Also, the strategy requires subjective analysis that must be done by hand rather than through automation. Instead, the study automated O’Neil’s methodology by merely investing in stocks that passed CANSLIM screening criteria. It’s likely that this testing approach didn’t faithfully follow O’Neil’s advice, simplifying the requirements for price behavior and fundamental strength.

Lutey, Crum, and Rayome (2013) tested a simplified version of CANSLIM on Nasdaq stocks, finding that from 1999-2013 the strategy had an average annual return of 14.21% compared to the Nasdaq 100 Index’s return of 3.82%. Its risk-adjusted performance, measured by the Sharpe ratio, was almost triple that of the index. But the researchers’ strategy only considered YoY quarterly EPS growth, annual EPS growth, institutional sponsorship, and price behavior. This finding is promising, but only somewhat helpful since it doesn’t test O’Neil’s full approach.

2006 saw the birth of the CANSLIM Select Growth Fund (CANGX), a mutual fund that invests its assets in CANSLIM stocks. Since its inception, it has failed to beat the market, consistently underperforming the S&P 500. In fairness, this shouldn’t surprise O’Neil fans. He stressed that funds face significant obstacles to outperformance. Their large asset base forces them to make large purchases when they want to invest in a stock. Such massive buying demand moves price against them, so they end up entering at a higher price than the ideal buy point. Many funds must avoid investing in small companies because their lower market caps increase the odds that their price will rise when the fund makes a large investment in them. Yet, these are often the best growth investments.

Beware of the academic studies that find that value stocks generally outperform growth stocks. Nearly all of them define growth stocks based on valuation ratios and nothing else. They ignore the defining trait of growth stocks: rapid, consistent earnings growth. These studies merely prove that cheaper stocks as a whole outperform pricier stocks as a whole over long-term timeframes. They don’t prove that growth investing approaches like O’Neil’s are inferior to a value investing approach. To compare value stocks and actual growth stocks, researchers must compare historically “cheap” stocks, based on valuation ratios, with young, innovative, small stocks that have staggering profitability growth and are reaching new highs while the rest of the market is uptrending. I’ve yet to encounter a single study that does so.

Very few stocks satisfy O’Neil’s strict criteria regarding fundamentals and price behavior. With few options, CANSLIM practitioners are forced to hold concentrated portfolios of about a dozen stocks or less. This, compounded with the more speculative and volatile nature of young growth stocks, exposes investors to wild portfolio fluctuations that try their emotional patience and may drive them to abandon the strategy.

The strategy works best during a bull market’s first two years. But bull markets last 6.6 years on average based on data from 1926 to 2018. This forces CANSLIM practitioners to sit on their hands for the majority of the market’s uptrend. It’s difficult to do nothing for years while the rest of the market makes impressive gains. Practitioners will be tempted to cave and buy more CANSLIM breakouts late in the cycle. O’Neil’s own website promotes this behavior, reporting on the latest breakouts and discussing buy points and stop loss levels without mentioning that these later opportunities have far lower success rates. At present (2019), the current bull market is at least 10 years old. In my personal experience, a large portion of recent CANSLIM breakouts have failed. In my view, O’Neil was right to urge investors to avoid picking stocks later in the market cycle. After a bull market’s first two years, practitioners may be better off just taking their profits and parking their funds in the general market for the remainder of the uptrend. You may be able to bump that two year time period to 6.6 years, the average bull market’s length, if you’re an experienced investor with a higher risk tolerance.

When explaining how to spot market tops, O’Neil offers no analysis of his method’s track record. Since he doesn’t quantify the thresholds that determine whether or not a rally is weak or strong, practitioners will struggle to systematically test his approach. The same is true for his method for spotting market bottoms. He mentions several price behavior characteristics that are favorable but not required, but then offers no advice on how heavily to weigh those characteristics. This is yet another impediment to objective backtesting.

O’Neil provides no empirical support for his preferred price pattern characteristics. He suggests investors favor chart bases with several “tight” trading weeks, meaning weeks with a small difference between their highs and lows, without offering evidence that this factor increases average future returns. He insists on requiring above average trading volume during breakout days without proving that this materially affects the strategy’s success rate. In fact, several famous traders have argued that volume doesn’t increase a breakout’s chances of success. Some believe high-volume breakouts are too well-known and thus less likely to deliver great returns.

O’Neil’s chart-reading approach is time-consuming, complex, and often subjective. Many of his chart reading examples appear to violate his own rules. And after studying them thoroughly, I noticed that many price patterns satisfy the requirements for multiple of his preferred base types. If the same portion of a chart looks like a flat base as well as a double bottom, which buy rules should you follow? O’Neil doesn’t offer guidance on these concerns.

Until faced with more evidence, investors may be better off simplifying O’Neil’s chart reading approach by following the method outlined by trading legend Jesse Livermore, one of O’Neil’s biggest inspirations. Livermore noticed that the best growth stocks tend to alternate between uptrends and plateaus that look like shallow boxes, recommending that investors buy stocks when they break above the box’s upper bound. All of O’Neil’s more complicated price patterns fall into the broad category of a price plateau or box. Investors can likely reap most of the benefits of O’Neil’s method by buying CANSLIM stocks as they break out of boxes that resemble a flat base or high and tight flag.

Mark Minervini’s Growth Investing Strategy

Minervini is another influential growth investor. From 1994 to 2000, Minervini grew his portfolio by 33,500%. This works out to an average annual return of 220%. Like O’Neil, he recommends investors buy stocks with strong fundamentals when they break out from key price patterns due to some noteworthy catalyst. He also urges investors to avoid buying stocks while the rest of the market is downtrending. However, his fundamental and price pattern requirements differ slightly from that of O’Neil. In addition, he offers several additional selection considerations beyond the “wash-over” and “follow-on” effects that O’Neil discusses.

Fundamentals

Minervini believes that prices fluctuate based on investor sentiment. Prices change when investors modify their future expectations or get surprised by new developments. His research found that earnings can cause both.

In his view, the best growth stocks should see analysts’ earnings forecasts rising, ideally by at least 5%. Quarterly and annual forecasts should be higher than they were last month. This mustn’t be required, but the reverse should disqualify the stock. He requires quarterly EPS YoY growth of at least 20% over the past three quarters, preferably with each quarter’s growth higher than the last’s.

He allows a company to have one or two quarters that fail to accelerate, assuming they still see at least a 20% YoY growth, as long as the company’s general EPS growth trend is rising; to check, he suggests plotting the most recent two quarters’ average EPS over the last 1-2 years.

Not all growth stocks have impressive prior earnings growth. Some begin their advances after their quarterly EPS finally breaks above a long-established plateau. He also sees promise in companies that are making a powerful comeback. The best comeback plays should have their current quarterly and annual EPS growth rates of at least 40% and far exceeding their growth rate over the past 3-5 years. The latter should be weakly positive, around 10%. In extreme comeback plays, a company with horrible past earnings should see triple digit YoY quarterly EPS growth over the past two quarters.

He has the most conviction in growth stocks with accelerating profit margins, sales, and earnings growth (YoY). These are the most likely “superperformers.”

Compared to O’Neil, Minvervini has far stricter standards for the quality of companies’ earnings. He wants the company’s net margin to be well above its industry’s average. He also avoids companies with an increasing ratio of inventories to sales, which often occurs when sales slump and/or management has previously overestimated future sales. He especially dislikes when firms’ inventories mostly contain items that rapidly depreciate, like computers and other retail products. He does note that inventory buildups can be acceptable for firms that recently spread to new locations.

For manufacturing firms, Minervini suggests investors avoid companies with an increasing amount of unsold finished products. These problematic companies see their finished goods inventories grow more than their raw material inventories. But the vice-versa is a plus. If companies’ raw material growth exceeds their finished goods growth, managers are betting on strong future demand. Before buying into their optimism, wait to see if sales growth accelerates soon after.

He also advises investors to beware of companies with accounts receivables accelerating or growing faster than sales. This suggests they are unable to gather payments from their buyers.

Some companies play sophisticated accounting tricks to mislead investors about their prospects to boost investor sentiment and keep their share prices keep climbing. To spot this, Minervini suggests looking for “differential disclosures,” instances where companies’ communications to shareholders differ from their reports to the SEC and IRS, which have more stringent requirements. If the footnotes in shareholder reports differ heavily from those in SEC filings, the company is likely trying to hide its deteriorating performance. When the secret gets out, the stock price can take a big hit. Also, Minervini says investors should be weary of companies reporting amazing earnings while also paying little in taxes. They may be fudging the numbers.

When a company releases a positive earnings surprise, Minervini urges investors to watch the firm’s share price behavior to confirm that the market’s optimism toward the stock is rising. The best breakouts hold strong, experiencing pullbacks that only partially reverse the initial upswing. After breaking out, some stocks will pullback enough to force you to cut your losses and sell. Don’t assume it will inevitably breakout again, but don’t blacklist the stock all together. If it forms another base and breaks out again, it can see huge gains, especially if the second base was even better than the first. Pros stay calm and patient, knowing that growth stocks can take two or three breakout attempts before rocketing higher.

Finally, after seeing an earnings surprise, Minervini also checks SEC filings to verify that the company is growing its market share and actively working to increase revenue and productivity, expand margins, and lower its costs.

Price Action Criteria

Unlike O’Neil, Minervini looks for stocks breaking out of one general base type, which he calls the “volatility contraction pattern” (VCP). It occurs when a stock plateaus and pulls back multiple times, with each drop shallower than the last. This signifies that the market’s selling enthusiasm is waning, and that investors are becoming more and more certain of the firm’s future value and that their optimism is increasing. O’Neil’s cup-with-handle pattern fits Minervini’s VCP template; it’s a VCP with two dips. Sometimes, the dips don’t get progressively shallower until the later portion of the base.

VCPs often have 2-6 dips, see light volume near the pattern’s lows, and are typically 3-65 weeks long. Ideally, each dip is about half as deep as the last, with none of them exceeding 35%. The tighter they are, the better. Minervini will also buy breakouts from flat, Livermore-style bases with depths between 10 and 15%. The ideal buy point occurs when the stock breaks above its most recent high, and on heavy volume. This is not necessarily the pattern’s overall high. But it’s even better if the stock breaks so strongly it reaches a new high.

Why? A large portion of selling activity results from investors exiting after they’ve recovered their losses. Say a stock has been trading at 100$ for a while, drops substantially, and then reaches 100$ again. You can expect the stock to pullback, since investors who had lost money after buying at 100$ have finally broken even and are just happy to exit with no loss. But once the stock breeches above that 100$ level and into a new high, none of the shareholders are just starting to break even. That source of supply no longer exists. When a bull market is just getting started, stocks making new highs are likely to be beginning massive runs.

Like O’Neil, Minervini isn’t afraid to buy high and sell higher. He understands that the best growth stocks will repeatedly make dozens of new highs while they experience their meteoric rises. For instance, after hitting new highs, Yahoo rose by 4300%, Microsoft rose by 5400%, and Monster Beverage soared 8000%. Not surprisingly, they also satisfied Minervini and O’Neil’s fundamental criteria before beginning these staggering uptrends.