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CANSLIM Stock Picking System

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CANSLIM is a highly talked about stock picking system developed by William O’Neil. The system combines both fundamental and technical analysis of stocks and is derived from the extensive research of greatest winning stocks each year for the last half-century. He does not believe in value investing or buying stocks at a bargain. He prefers to pick leaders who can make a significant price movement in the near future.

C – Current Quarterly Earnings per Share: The Higher, the Better

Earnings per share (EPS) is calculated by dividing a company’s total after-tax profits by the number of common shares outstanding. Select stocks that show a major percentage increase in current or most recent quarterly EPS as compared to the same quarter in the previous year. Do not be misled by words like “sales” or “income”, as increment in this area does not equate to the same increment in EPS. A 12% increment in sales may only mean a 5-6% increment in EPS. Thus, focus on EPS and look at increment of at least 25%-50% and even 100%-500% during a bull market.

What to look out for?

  • Ensure the increase in EPS is due to improved sales and not other reasons like cost reductions. Hence, besides a large increment in EPS, look for sales growth of at least 25%.
  • Ensure the increase in EPS is not brought about by a one-time extraordinary gain like sale of company’s large assets.
  • Look for accelerating quarterly earnings and avoid companies with deccelerating quarterly earnings. Plot the current quarter earnings with previous three quarters on a logarithmic-scale graph to see the acceleration/decceleration clearly.
  • Ensure there are other impressive stocks in the same industry group displaying strong earnings too.

A – Annual Earnings Increases: Look For Significant Growth

Annual earnings should increase at a rate of 25-50% for the past 3 years. This process should have weeded out 80% of the stocks.

What to look out for?

  • Look out for more stable and consistent past earnings growth. When several years of earnings are plotted on a log graph, it should appear nearly as a straight line going upwards.
  • Beware of cyclical stocks as their rallies tend to be short-lived and may top out at peaks or at cycle ends. Examples of cyclical stocks are paper, aluminium, autos, chemicals, plastics and home-building.
  • Price-Earnings Ratio (P/E ratio) is not an important factor to determine whether a stock is underpriced or overpriced. It is an effect, not a cause. There are a handful of stocks with high P/E ratios (25 to 50) end up with even higher ratios (60-115). Value buyers would have missed out these great stocks.

N – New Products, New Management, New Highs: Buying at the right time

New products that can revolutionalize the way we live can help the company achieve enormous profits. Many investors believe in “buy low, sell high” and usually buy stocks that look like bargains when they are down in price. On the contrary, what seems too high in price to the majority usually goes higher – likewise for stocks that are on new-highs. To determine when to buy these stocks is to look at its price movement on the chart. The buy point should be at the point where new high is reached after it breaks out of its price consolidation areas. The consolidation can range from 7 weeks to 15 months. Avoid buying if the price has increased 5-10% from the exact buy point.

S – Supply and Demand: Shares outstanding plus big volume demand

Small-cap stock prices are more volatile as compared to large-cap stocks. This is due to the lower number of outstanding stocks and thus, a reasonable amount of buying can push up the price significantly. When a stock rallies in price, you expect the volume to rise in tandem. When it breaks out of price consolidation area, trading volume should be at least 50% above normal.

What to look out for?

  • Select companies with management owning a large percentage of the stocks, as they have a greater interest in the business.
  • Look for companies that make share buybacks in the open market. In this way, EPS would increase as the number of outstanding shares is reduced.
  • The debt ratio of the companies should be as low as possible to avoid losses in high interest periods. Consider companies that make efforts to reduce their debts over the past 2-3 years.
  • Look out for the presence of convertible bond, which when converted into shares can dilute the earnings.

L – Leader or Laggard: Which is your stock?

Choose the top two or three leaders of a strong industry group based on quarterly and annual earnings growth, return on equity, profit margin, sales growth, and price action. The chances of success are increased if these companies have innovative products or services. In your portfolio of stocks, always sell the losers and keep the winners. To find out, check Investor Business Daily’s Relative Price Strength (RS) Rating. Each stock is rated in the range of 1 to 99 and 99 being the best. A rating of 99 means the stock outperformed 99% of all other companies in price performance. Consider stocks that have RS rating of 80 and higher. Market corrections can also show which are the leaders – those which declines the least in the decline and likely to be the first few to bounce back after the correction. Remember: Do not buy stocks based on “good feel”, follow the system mechanically.

I – Institutional Sponsorship: Follow the Leaders

Institution sponsorship is crucial because they can move stock price with their high volume demand. It is preferable for a particular stock to have at least 10 institutions (mutual funds, trusts, etc) investment in it. Going a step further, analyze the activity (buying and selling) of institutions regarding this stock in recent quarters, and also find out the performance of these institutions in the recent 12 months and past 3 years. There should be increasing amount of sponsorship to prove the attractiveness of the stock. On the contrary, too much institutional sponsorship may not be a wise choice as a large sell off of the stock would dramatically bring the stock price down.

M – Market Direction: How to Determine It

Study the general stock market direction everyday. Dow Jones Industrial Average, Standard & Poor 500 and NASDAQ are the 3 indices that represent the general market (in US).

What to look out for?

  • If the volume in the indices are increasing but the their values remain more or less the same, it actually tells you that investors are liquidating the stocks and thus, serves as a warning that the market has topped
  • After the market tops out, the attempted rally will be weak and eventually fails – opens strongly and closes down. There will be 3 signs to look out for: Firstly, the indices advance but on lower volume than the previous day; Secondly, the advancement in price is lesser than the day before; Thirdly, each average recovers less than half of the initial drop from its former absolute intraday high

How to spot the uptrend?

  • Most of the profits are made in the first two years of the bull run and thus, it is important to spot the market turnaround.
  • Monitor the daily index averages, it takes 3 to 4 days of rallies (or known as follow through) in both price and volume, to mark the start of a bull run. The averages should go up by 1-2% than previous day on heavy volume to be considered a follow through day.
  • Make sure all 3 averages are showing equivalent advancements
  • Observe the volume of call and put options. Higher call options volume indicates bullish sentiments among the investors.

Visit http://www.investors.com/ to find out more – they conduct workshops and you can also subscribe to their newspaper and research tools which can aid you in CANSLIM stock selection. You can also buy his book, “How to Make Money In Stocks”, which is a cheaper alternative.

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