William O’Neil – Stock Selection

William O'Neil

This article is part of our 'Guru' series - profiles of successful traders, with takeaways for the UK private investor.
You can find the rest of the series here.


Today’s post is a profile of Guru investor William O’Neil, who appears in Jack Schwager’s original Market Wizards. His chapter is called The Art of Stock Selection.

William O’Neil

William O'Neil

William O’Neil began his financial career as a stockbroker for Hayden, Stone and Company in 1958. His trading concepts proved remarkably effective from the start.

During 1962-63, by pyramiding three exceptional back-to-back trades he managed to parlay an initial $5K investment into $200K. “He used his winnings to buy a seat on the New York Stock Exchange and to start a successful institutional research brokerage firm.

In 1988, O’Neil he wrote How to Make Money in Stocks, the best-selling investment book of the year.

O’Neil appears in Jack Schwager’s original Market Wizards.

  • His chapter is called The Art of Stock Selection.

Schwager describes O’Neil as an optimist:

Your own determination to succeed is the most important element.

Performance

In the 10 years preceding Schwager’s interview, O’Neil averaged more than 40% a year – in stocks.

  • Pretty impressive.
Early days

Schwager asked O’Neil where he developed his trading style:

I subscribed to a few investment letters and most of them didn’t do too well. I found that theories like buying stocks with low P/E ratios were not very sound.

Back in 1959,1 did a study of the Dreyfus fund. I plotted on charts precisely where they had purchased each of their stocks. Every single stock had been bought when it went to a new high price.

To get superior performance, buy stocks that are coming out of broad bases and beginning to make new highs relative to the base. You are trying to find the beginning of a major move.

I would generally not buy a stock that is already more than 10% beyond its prior price base.

This sounds an awful lot like Weinstein and Minervini.

I studied the stocks that were big winners in past years and tried to find the characteristics they had in common. I examined a lot of variables to develop a model based on how the real world worked.

CANSLIM

O’Neil uses an easy-to-remember acronym – CANSLIM.

“C” stands for current earnings per share.

There is absolutely no reason for a stock to go up if the current earnings are poor.

The best performing stocks showed a 70% average increase in earnings for the current quarter over the same quarter in the prior year before they began their major advance.

Our first basic rule is that quarterly earnings per share should be up by at least 20 to 50% year to year.

“A” stands for annual earnings per share.

The prior five-year average annual compounded earnings growth rate of outstanding performing stocks was 24%.

O’Neil had his own investment paper – Investor’s Daily – which published a measure called EPS rank.

  • This combined earnings growth for the previous two quarters and the last five years, ranking each stock within the market.
  • This is a similar approach to that currently used by Stockopedia for Quality, Momentum and Value.

“N” stands for something new.

The “new” can be a new product or service, a change in the industry, or new management. Ninety-five percent of the greatest winners had something new.

“New” also refers to a new high price – 98% of investors are unwilling to buy at a new high.

“S” stands for shares outstanding.

95% of the best stocks had less than 25M shares outstanding during their best period. The average was 12M and the median less than 5M.

“L” stands for leader or laggard.

The 500 best-performing stocks from 1953-1985 period had an average relative strength of 87 before their major price increase. I tend to restrict purchases to companies with relative strength ranks above 80.

Relative strength is a market ranking that is widely available in the US.

“I” stands for institutional sponsorship.

The institutional buyers are by far the largest source of demand for stocks. However, excessive sponsorship is desirable, because it would be a source of large selling if anything went wrong with the company or the market in general.

“M” stands for market.

Three out of four stocks move with the market averages. So you need to interpret price and volume for signs that the market has topped.

System features

O’Neil says that:

At any given time, less than 2 percent of the stocks in the market will fit the CANSLIM formula.

He also says that around two-thirds of his trades are profitable, though:

Only one or two stocks of every ten I have bought have turned out to be truly outstanding.

Tops

Top formations in the market averages occur in only one of two ways. First, the average moves up to a new high, but does so on low volume. This tells you that the demand is poor and the rally is vulnerable.

Second, volume surges for several days, but there is very little, if any, upside price progress. The distribution has taken place on the way up.

Another option is to focus on how the leading stocks are performing. If the leaders start breaking down, that is a major sign the market has topped.

Another way is to watch the Federal Reserve discount rate. Usually, after the Fed raises the rate two or three times, the market runs into trouble.

The daily advance/decline line is sometimes a useful indicator.

This is the difference between the number of stocks advancing each day and the number declining.

The advance/decline line will lag behind the market averages and fail to penetrate prior peaks after the averages reach new highs. This indicates that fewer stocks are participating in the market advance.

Risk control

All stocks are bad unless they go up in price. If they go down, you have to cut your losses fast.

“You should be able to win even if you are right only half the time. The key is to lose the least amount of money possible when you are wrong.

O’Neil uses a maximum 7% stop-loss, which he says is fine if you buy the breakout from a base.

Letting losses run is the most serious mistake made by most investors. If you aren’t willing to cut your losses short, then you probably should not buy stocks. Would you drive your car without brakes?

Selling

You should hold a stock as long as it is performing properly. You will never sell the exact top.

The goal is to make substantial profits on your stocks and not be upset if the price continues to advance after you get out.

Charts

Investors would be foolish not to use charts. Charts provide valuable information about what is going on that cannot be obtained easily any other way.

They allow you to follow a huge number of different stocks in an organized manner.

Volume

Volume is a measure of supply and demand.

When a stock is beginning to move into new high ground, volume should increase by at least 50 percent over the average daily volume in recent months.

High volume at a key point is an extraordinarily valuable tip-off that a stock is ready to move.

When prices enter a consolidation after an advance, volume should dry up very substantially.

Losing streaks

If you hit a losing streak, that tells you the whole market may be going bad.

If you have five or six straight losses, you want to pull back to see if it is time to start moving into cash.

Mutual funds and real estate

I believe that every person should own their own home, own real estate, and have an individual stock account or own mutual funds. Those are the only ways you can make any substantial income above your salary.

The key to success in mutual funds is to sit and not to think. You need the courage to sit through three, four, or five bear markets.

Mistakes

There are a lot of things that O’Neil doesn’t believe in.

See also:  Tom Basso - Mr Serenity
Shorting

“I don’t normally advise retail investors to sell short. A stock should never be sold short because its price looks too high. The idea is not to sell short at the top.

Shorting of individual stocks should only be considered after the general market shows signs of a top.

The stock should be breaking down toward the low end of its previous base pattern on increased volume. After the first serious price break below the base, there will usually be several pullback attempts.

The prior base will now provide an area of overhead supply, as all investors who bought in that zone will be losing money, and a number of them will be eager to get out near break-even.

Therefore, pullbacks to failed price bases also provide good timing for short sales.

Once again, this sounds very similar to Weinstein and Minervini.

PE

To say that a stock is undervalued because it is selling at a low P/E ratio is nonsense. There is usually a very good reason why a P/E ratio is low.

The average P/E ratio for the best-performing stocks at their emerging stage was 20, compared to an average P/E ratio of 15 for the Dow Jones Average during the same time.

At the end of their expansion phase, these stocks had an average P/E ratio of approximately 45.

If you were not willing to buy stocks with above-average P/Es, you automatically eliminated most of the best-performing securities.

Dividends

There is no correlation between dividends and a stock’s performance.

The more a company pays in dividends, the weaker their posture because they may have to pay high interest rates to replace funds paid out in dividends.

Indicators

I rarely pay any attention to overbought / oversold indicators.

Diversification

Diversification is a hedge for ignorance. I think you are much better off owning a few stocks and knowing a great deal about them.

By being very selective, you increase your chances of picking superior performers. You can also watch those stocks much more carefully, which is important in controlling risk.

For an investor with $100,000 or more, I would recommend six or seven stocks.

Research

Top-rated analysts generally under-performed the S&P average.

80% of research is written on the wrong companies. Each analyst has to turn out his quota, even though only a few industry groups are leaders in each cycle.

And Wall Street research seldom provides sell recommendations.

Efficient market theory

The stock market is neither efficient nor random. There are too many poorly conceived opinions.

And strong investor emotions can create trends.

Rules

Schwager reproduces a list of rules to avoid the most common mistakes made by investors, taken from O’Neil’s book How to Make Money in Stocks.

  • Strangely, they aren’t up to the standard of the rest of the interview.

Here are my shortened and paraphrased versions:

  1. Use good selection criteria (like CANSLIM).
  2. Don’t buy stocks on the way down – buy stocks at new highs.
  3. Run your winners, and cut your losses.
  4. Don’t average down.
  5. Don’t buy stocks with the lowest share prices (penny stocks).
  6. Don’t be in a hurry.
  7. Don’t follow tips, rumours or analyst recommendations.
  8. Don’t buy for high dividends, or because of low PE.
  9. Don’t rely on familiar companies.
  10. Don’t worry too much about taxes and commissions.
    • I disagree with this one, but more over the long-term than in the sense that O’Neil means.
    • Which is that you shouldn’t let an obsession with commissions and taxes get you into (or keep you in) a poor investment.
  11. Be careful with options – don’t speculate in naked, short-term option writing.
  12. Don’t use limit orders, especially on stop losses when you need to get out.
    • I don’t have a problem with limit orders on the way in, but they matter less for the kind of breakout stocks that O’Neil specialises in.
  13. Have a plan and a set of rules – hopes and opinions are not a plan.
See also:  Michael Lauer - Value over Fad - Investor Profile
Conclusions

Schwager says that:

Trading success requires three basic components: an effective selection process, risk control, and discipline. William O’Neil provides a perfect illustration.

This is one of the best chapters in any of Schwager’s books – short, yet packed with practical advice that can be relatively easily applied by the private investor in stocks.

CANSLIM is reasonably simple, and makes sense.

I’ll be back in a few weeks with a stock screen based on O’Neil’s teachings.

Until next time.

Mike Rawson

Mike is the owner of 7 Circles, and a private investor living in London. He has been managing his own money for 35 years, with some success.

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