Knowing what stock to buy and when to buy it is an important skill every investor should have but one which many lack. In other words, not many people who invest in the stock market know how to find and evaluate stocks.
And this is the reason most people lose money or get frustrated.
Professional investors use either of two methods to screen stocks. These are Fundamental Analysis and Technical Analysis.
Fundamental analysis examines key financial ratios and developments that may impact the performance of a company. This works on the understanding that whatever affects the performance of a company, will likely impact on its share price.
Thus, a Fundamental analyst evaluates quantitative factors such as sales, revenues, profits, assets, etc; and non quantitative factors like quality of the company’s management. Economic developments such as interest rates and exchange rates are also of importance when analyzing a company fundamentally.
This is because macro economic conditions prevailing at any given time may impact positively or negatively on business performances.
Technical analysis on the other hand, uses historical price and volume data to predict the likely future price of a stock. The technical analyst uses a wide range of charts to determine the behavioral pattern of a stock in order to estimate its likely price at a any particularly point in time.
What Method Should I Use to Find Stock to Buy?
I get questions like this very often in my inbox.
If you are serious about investing, you should at least have a basic understanding of both fundamental and technical analysis. The reason is that both are useful tools.
While fundamental analysis helps you decide what stock to buy, technical analysis tells you when to buy.
And this is important irrespective of the instrument involved: stocks, commodities, futures, etc., as long as their prices are driven by the forces of demand and supply.
In this discussion, I will show you a tool which combines both fundamental and technical analysis to evaluate stocks. This tool tells you what stock to buy and when to buy it. And even when to sell. Professional and savvy investors have used this tool for years to beat the market consistently.
It is the CAN SLIM investing strategy
CAN SLIM Explained
It is a proven, fact based system that provide rules for buying and selling stocks. Developed by William J. O’Neil, the system is derived from the analysis of the greatest winning stocks over a period spanning half a century.
The Investor Business Daily, an American financial news and research organization popularized the CAN SLIM investing strategy over the years. With this strategy, an investor is sure to maintain a portfolio that consistently outperforms the broad market.
This is because it helps you select winning stock. It also helps you to allocate greater percentage of your capital to superior companies while reducing risks by under allocating or conserving cash in weak markets.
Focusing on both a company’s fundamentals and market technical the CAN SLIM strategy helps to identify companies that show acceleration in earning and suggest buying them before they witness a major spike in price.
This techno-fundamental method of analyzing stocks, as it were, ensures that the investor select quality stocks to buy at all times.
7 Ways to Find and Evaluate Stock to Buy Using CAN SLIM
The CAN SLIM investing strategy prescribes 7 criteria investors can use to evaluate and find stock to buy in all market conditions. The first letter of each of the seven criteria when combined together forms the mnemonics CAN SLIM.
These criteria are as follow:
C – Current Quarterly Earnings Per Share
A – Annual Earnings Growth
N – New Products, Services or Management
S – Supply and Demand
L – Leader or Laggard
I – Institutional Sponsorship
M – Market Direction
Now in Details..
Current Quarterly Earnings Per Share
When deciding on a stock to buy, quarterly earnings growth is an important factor to consider. The stock you select must show an increase in quarterly earnings (EPS) by at least 20% – 25% for the most recent quarter. And also for the last two or three quarters.
This is the minimum, the bigger the better. In a bull market, i.e, in a period of rising stock prices, look for stocks with quarterly EPS growth of about 40% and above.
Annual Earnings Growth
Quarterly earnings growth are not just enough. The reason is that the fantastic current quarter earning you are looking at may just be a flash in the pan.
You will need more proof. And that proof you can get from looking at the annual EPS growth for the past three years. If this is solid within the 20% – 25% region, then it could be validation you need to prove that the company is solid.
The combination of strong earnings in the last few quarters ( say 3 to four quarters) plus a record of solid growth in recent years, create a winning stock.
New Product, Management, Highs
According to CAN SLIM founder, William J. O’Neil, it takes something new to produce a startling advance in the price of a stock. And as studies have shown, great stock market winners in the past all had something new.
In the world of business, Innovation is key. Companies which invest in research and come out with new and better ways of doing things, new products that add more value, better services, etc, rule the market.
So in selecting a stock to buy, pay attention to innovative companies or companies that are experiencing positive changes.
This new things could be:
Product or services that’s disrupting the market and generating huge sales or earnings
CEO or management with smart industry ideas that are of benefits to the company
New Technology or trend that could revolutionize service delivery
Innovations help businesses to generate stellar profits.
Supply and Demand
The law of demand and supply is an important economic model that determines prices of commodities. In stock investing, this law applies.
The scarcer the stock, the more likely the price will be high. And the more people that want to buy the stock, the more likely that the price will go up.
In selecting a stock to buy, it is important that you consider the outstanding shares (i.e the number of shares that is in circulation) and also the demand for these shares.
The higher the number of shares outstanding, the higher the volume of demand needed to prop up the share price. The reverse is also true.
So the rule is to look out for those stocks with not too much share outstanding but with reasonable volume increase. As more investors want to buy a stock with limited supply, the price goes up.
Also look out for stock in which management hold at least 2 – 3% interest. Or more, in smaller companies. Such shares usually present better prospect.
Leader or Laggard
Look out for stocks that lead in their sectors not ones that lag behind. Buy the best of the best, the leaders in hot industries and ones that are posting superior results in sales and earnings.
Now this is very important….
The stock that is an industry leader is not usually the one with the most recognized brand or the largest in the industry.
The leader is the company with the best quarterly and annual earnings growth, return on equity, sales growth, profit margins and price action. Such a company will usually have an innovative product and increasingly gaining market share from its older but less innovative competitor.
Technically, these are stocks with 80 or above rating in Relative Price Strength (RS) and rising Relative Strength line, around the 52 week average.
Institutional investors account for about 75% of market activities.
The degree of interest institutional investors are showing in a stock is referred to as institutional sponsorship. Institutional investors include: Mutual Funds, Pension Funds, Insurance Companies, Investment Banks.
Watch out for stocks which they are buying. It takes big demand to drive up prices of stocks and institutional investors do buy really big. And often sell big too.
If institutional investors are not buying a particular stock, that stock is probably not worth buying. Observe Mutual Funds who are producing superior returns and watch out for the stocks they are buying.
These are very likely to be winners.
Professional investors (or institutional investors) have qualified analysts who are constantly reviewing the market and researching hundreds, if not thousands of stocks. So it’s a validation to see that they are buying a stock that you are considering to buy.
A study of the stock market shows that 75% of stocks follow the general market direction. Hence, it is very important that you learn to understand and interpret market direction at all points in time.
If you fail to correctly interpret the market direction, it means that you 3 out of 4 of your investment will fall with market averages and you will lose money big time.
It is therefore advised that in your analytical tool kit is a reliable method to determine when you are in a bull market or a bear market.
Most importantly, you should know at which stage the cycle is at the prevailing time. For example, if a bull market, is it at the early stages or is it nearing a reversal?
Understanding and interpreting what the daily market averages are, is the best way to determine the direction of the market.
The CAN SLIM rule here is to only make new purchases in an uptrend market and take defensive action as the market begins to weaken.
If you buy a stock when the general market is in a strong uptrend, you have a 75% chance of being right. And if you buy when the market is in downtrend, you have a 75% of being wrong.
This is irrespective of how accurate you are with the other six criteria. The ‘M’ in CAN SLIM is thus, the most important.
Do you want to buy a stock that is a winner? Learn, understand and interpret the general direction of the market correctly. The general direction of the market is defined by the market index: Dow Jones Industrial Average, S&P 500, NASDAQ Composite. Not to forget the NSE All Share Index (ASI).
Does It Work?
CAN SLIM has been examined empirically by quite a number of researchers. It has also been tested by analysts and investors in different markets. And the result of back testing has been impressive.
It’s been found that the strategy is effective and in most cases outperforms the broad market by very high percentages.
So to the question: Dose it Work?
Yes it does.
The thing with the strategy is that even though it is intended for individual investors, its application may not be that easy. In practice, it requires some degree of technical knowledge to effectively use, a knowledge that may not be readily available to newbies.
To understand, CAN SLIM strategy and its application very well, it is recommended that you read the book “How to Make Money In Stocks: A Winning System In Good Time or Bad”, written by William J. O’Neil. In that book, O’Neil discusses in detail the CAN SLIM approach to stock investing.
What to do now?
Develop a stock screener based on the seven criteria. Some investors use a simplified version of the strategy and still achieve remarkable results.
Effectiveness of any trading system depends on how well the trader understands the system and his ability to execute the system diligently, consistently and with discipline.