How to Make Money in Stocks

~William O'Neil

Introduction, Important Lessons;

• You buy stocks when they're on the way up in price, not on the way down. And when you buy more, you do it only after the stock has risen from your purchase price, not after it has fallen below it.

• You buy stocks when they're nearer to their highs for the year, not when they've sunk lower and look cheap. You buy higher-priced, better quality stocks rather than the lowest-priced stocks.

• You learn to always sell stocks quickly when you have a small 7 or 8% loss rather than waiting and hoping they'll come back. Many don't.

• You pay far less attention to a company's book value, dividends, or PE ratio - which for the last 100 years have had little predictive value in spotting America's most successful companies - and focus instead on vital historically proven factors such as strong earnings and sales growth, price and volume action, and whether the company is the number one profit leader in its field with a superior new product.

• You don't subscribe to a bunch of market newsletters or advisory services, and you don't let yourself be influence by recommendations from analysts, or friends who, after all, are just expressing personal opinions that can frequently be wrong and prove costly.

• You also must acquaint yourself with daily, weekly, and monthly price and volume charts - an invaluable tool the best professionals wouldn't do without but amateurs tend to dismiss as irrelevant.

• Lastly, you must use time-tested sell rules to tell you when to sell a stock and take your worthwhile gains. Plus you'll need buy and sell rules for when it's best to enter the general market or sell and lower your percent invested. Ninety percent of investors have neither of these essential elements.

O'Neil is famous for his CAN SLIM strategy

Each letter in the words CAN SLIM stands for one of the seven chief characteristics of the greatest winning stocks at their earliest development stages, just before thye made huge profits for their shareholders

The reason CAN SLIM continues to work cycle after cycle is that it’s based

solely on the reality of how the stock market actually works rather than on our

personal opinion or anyone else’s, including Wall Street’s.

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

A Annual Earnings Increases: Look for Significant Growth

N New Products, New Management, New Highs: Buying at the Right Time

S Supply and Demand: Shares Outstanding Plus Big Volume Demand

L Leader or Laggard: Which Is Your Stock?

I Institutional Sponsorship: Follow the Leaders

M Market Direction: How to Determine It

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Reading the Charts

You want the stock to follow the CAN SLIM criteria, and then the general idea is to try to identify stocks under accumulation.

Chart patterns, or “bases,” are simply areas of price correction and

consolidation after an earlier price advance. Most of them (80% to 90%) are

created and formed as a result of corrections in the general market.

The skill you need to learn in order to analyze these bases is how to diagnose whether

the price and volume movements are normal or abnormal. Do they signal

strength or weakness?

Cup & handle

On the charts, you want price to have rallied in a prior move, and then during a market correction we are looking for a base to form. That base takes the shape of a cup and handle.

O'Neil notes; Cup patterns can last from 7 weeks to as long as 65 weeks, but most of them last for three to six months.

When a base is formed, and price rallies to midrange or range highs, dips below and gets back above, while being above the 10 week moving average, it appears to be a good buy in Williams view.

Also beware if the 'handle' area is formed in a wedging up pattern, as opposed to dipping back below midrange, as they are more prone to failure.

Volume should probably fall off during handle phase and pick up at the top (which by definition is at the top of the range)

Nearly all proper bases will show a dramatic drying up of volume for one or two weeks along the very low of the base pattern and in the low area or few last weeks of the handle. This means that all of the selling has been exhausted and there is very little stock coming into the marketplace. Healthy stocks that are under accumulation almost always show this symptom. The combination of tightness in prices (daily or weekly price closes being very near each other) and dried-up volume at key points is generally quite constructive)

Basically, you want to see areas in the base with an extremely tight weekly range.

If the base pattern has a wide spread between the week's high and low points every week, it's been constantly in the markets eye and frequently will not succeed when it breaks out.

A strong price pattern of any type should always have a clear and definite price uptrend prior to the beginning of its base pattern.

The bottom part of the cup should be rounded and give the appearance of a “U” rather than a very narrow “V.” This characteristic allows the stock time to proceed through a needed natural correction, with two or three final little weak spells around the lows of the cup. The “U” area is important because it scares out or wears out the remaining weak holders and takes other speculators’ attention away from the stock. A more solid foundation of strong owners who are much less apt to sell during the next advance is thereby established

Basic characteristics of a cup's handle area

The formation of the handle area generally takes more than one or two weeks and has a downward price drift or "shake-out" (where the price drops below a prior low point in the handle made a few weeks earlier), usually near the end of its down-drifting price movement. Volume may dry up noticeably near the lows in the handle's price pullback phase.

Double-Bottom

A “double-bottom” price pattern looks like the letter “W.” This pattern also doesn’t occur quite as often as the cup with handle, but it still occurs frequently. It is usually important that the second bottom of the W match the price level (low) of the first bottom or, as in almost all cases, clearly undercut it by one or two points, thereby creating a shakeout of weaker investors.

Failure to undercut (swing-fail) may make failure more likely.

Bases on top of Bases

Sometimes a powerful stock is forming a base, with a handle, and is ready to break out. If this breakout is hindered by a general downturn in the market, a new base often forms on top of the base that has just been formed.

When the bearish phase in the general market ends, this stock is likely to outperform, like a spring being held down by a heavy object. Once that heavy object is removed (the bear market), the spring does what it wanted to do all along.

In other words, if you see a promising base developing, but then the market puts in another down move, don't give up on that stock, get ready to buy when conditions change.

Head and Shoulders

Unreliable when forming bottoms apparently. Very reliable when forming tops, but must be analysed correctly - the right shoulder should be slightly below the left.

Other patterns

O'Neil basically hates triangles, flags, penants and other shorter term consolidation patterns; says they don't have enough time to form a proper base to be reliable patterns.

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Using relative price strength correctly

It's not enough to buy stocks that show the highest relative price strength on some list of best performers. You should buy stocks that are performing better than the general market just as they are beginning to emerge from sound base-building periods. The time to sell is when the stock has advanced rapidly, is extended materially from its base, and is showing extremely high relative price strength.

Overhead Supply

A critically important concept to learn in analyzing price movements is the

principle of overhead supply. Overhead supply is when there are significant

areas of price resistance in a stock as it moves up after experiencing a

downtrend.

These areas of resistance represent prior purchases of a stock and serve to

limit and frustrate its upward movement because the investors who made

these purchases are motivated to sell when the price returns to their entry

point.

For example, if a stock advances from $25 to $40, then declines back to $30, most of the people who bought it in the upper $30s and at $40 will have a loss in the stock unless they were quick to sell and cut their loss (which most people don’t do). If the stock later climbs back to the high $30s or $40 area, the investors who had losses can now get out and break even.

These are the holders who promised themselves: “If I can just get out even, I will sell.” Human nature doesn’t change. So it’s normal for a number of these people to sell when they see a chance to get their money back after having been down a large amount.

Good chartists know how to recognize the price zones that represent heavy

areas of overhead supply. They will never make the fatal mistake of

buying a stock that has a large amount of recent overhead supply. This is a

serious mistake that many analysts who are concerned solely with

fundamentals sometimes make

A stock that’s able to fight its way through its overhead supply, however, may be safer to buy, even though the price is a little higher. It has proved to have sufficient demand to absorb the supply and move past its level of resistance. Supply areas more than two years old create less resistance. Of course, a stock that has just broken out into new high ground for the first time has no overhead supply to contend with, which adds to its appeal.

The big secret is for youto combine skillful chart reading with stocks that have outstanding earnings and sales growth, plus superior returns on equity or pre-tax profit margins. You need both fundamentals and chart reading, not just one or the other.

You absolutely do not buy break-outs during a bear market. Most of them will fail.

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C = Current Big or Accelerating Quarterly Earnings and Sales per Share

The characteristic that stood out the most among all stats that big winners shared was a huge increase in EPS in the latest quarter or 2 before its big price advance.

The stocks you select should show a major percentage increase in current quarterly earnings per share (the most recently reported quarter) when compared to the prior year’s same quarter

The earnings per share (EPS) number you want to focus on is calculated by dividing a company’s total after-tax profits by the number of common shares outstanding.

This percentage change in EPS is the single most importantelement in stock selection today. The greater the percentage increase, the better.

There is absolutely no good reason for a stock to go anywhere in a big, sustainable way if its current earnings are poor.

Even profit gains of 5% to 10% are insufficient to fuel a major price movement in a stock. Besides, a company showing an increase of as little as 8% or 10% is more likely to suddenly report lower or slower earnings the next quarter.

Following the CAN SLIM strategy’s emphasis on earnings ensures that an investor will always be led to the strongest stocks in any market cycle, regardless of any temporary, highly speculative “bubbles” or euphoria. Of course, you don’t buy on earnings growth alone. Several other factors are almost as important. It’s just that EPS is the most important.

Misleading Earnings Reports

"Greatshakes Corporation reports record sales of $7.2 million versus

$6 million (+20%) for the quarter ended March 31."

But is this “record-breaking” sales announcement a good report? Let’s suppose the company also had record earnings of $2.10 per share, up 5% from the $2.00 per share reported for the same quarter a year ago. Is it even better now? The question you have to ask is, why were sales up 20% but earnings ahead only 5%? What does this say about the company’s profit margins?

Most investors are impressed with what they read, and companies love to

put their best foot forward in their press releases and TV appearances.

However, even though this company’s sales grew 20% to an all-time high, it

didn’t mean much for the company’s profits.

The key question is:

How much are the current quarter’s earnings per share up (in percentage

terms) from the same quarter the year before?

Let’s say your company discloses that sales climbed 10% and net income advanced 12%. Sound good?

Not necessarily. You shouldn’t be concerned with the company’s total net income. You don’t own the whole organization; you own shares in it. Over the last 12 months, the company might have issued additional shares or “diluted” the common stock in other ways. So while net income may be up 12%, earnings per share - your main focus as an investor - may have edged up only 5% or 6%.

You must be able to see through slanted presentations. Don’t let the use of words like sales and net income divert your attention from the truly vital facts like current quarterly earnings. To further clarify this point:

You should always compare a company’s earnings per share to the same quarter a year earlier, not to the prior quarter, to avoid any distortion resulting from seasonality. In other words, you don’t compare the December quarter’s earnings per share to the prior September quarter’s earnings per share. Rather, compare the December quarter to the

December quarter of the previous year for a more accurate evaluation.

Omit a Company's One-Time Extraordinary gains

Don't allow yourself to be influenced by non-recurring profits.

i.e. If a computer maker reports profits from activities such as the sale of real estate, this portion of earnings should be subtracted from the report.

This type of one-off event doesn't represent ongoing profitability of corporate operations.

Set a Minimum Level for Current Earnings Increases

Advises against buying stocks that don't show EPS up at least 18% or 20% in the most recent quarter vs the same quarter in the previous year.

In their research they found that all the best gainers reported these type of increases in the quarter prior to their big upswings. An even higher level of 25% or 30% can be used also. You have thousands of stocks to choose from - buy the very best.

Look for Accelerating Quarterly Earnings Growth

In almost every case, for the best companies, earnings growth accelerated sometime in the 10 quarters before a towering price move began.

Similarly, be wary of a material slow-down in growth. Any company can have a bad quarter, but 2 quarters of noteworthy underperformance should ring alarm bells. A two thirds slowdown is significant.

Insist on Sales Growth as Well as Earnings Growth

Strong and improving quarterly earnings should always be supported by sales growth of at least 25% for the latest quarter, or at least an acceleration in the rate of sales percentage improvement over the last three quarters.

Take particular note if the growth of BOTH sales and earnings has accelerated for the last 3 quarters.

- Companies can inflate earnings for a few quarters by reducing costs or spending less on advertising, r&d, and other activities. To be sustainable however, earnings growth must be supported by higher sales.

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A = Annual Earnings Increases: Look for Big Growth

To make sure the latest company you're looking at isn't just a flash in the pan, you need more proof than the last quarters.

Review their annual earnings growth rate.

Look for annual EPS that's increased for the last 3 years.

It's the combination of strong earnings in the last several quarters plus a record of solid growth in recent years that creates a super stock.

Look for 25% - 50%+ annual earnings growth rate..

e.g. for the previous 5 years it might look like;

$0.70, $1.15, $1.85, $2.65, $4.00

If a 3 year history, you don't really want any down years. In a 5 year history, you might accept 1 down year if the next rebounded suitably.

Look for a big return on equity

ROE is calculated by dividing net income by shareholders equity. It shows how efficiently a company uses its money.

It separates well managed firms from those that are poorly managed.

Nearly all great stocks had ROEs of at least 17% with some has high as 25 or 50%.

What is a Normal Stock Market Cycle?

History demonstrates most bull markets last two to four years and are followed by a recession or a bear market. Then another bull market starts.

In the beginning phase of a new bull market, growth stocks are usually the first to lead and make new price highs. These are companies whose profits have grown quarter to quarter but whose stocks have been held back by the poor general market conditions.

The EPS Rating

The EPS Rating measures a company’s two most recent quarters of

earnings growth against the same quarters the year before and examines

its growth rate over the last three years. The results are then compared

with those of all other publicly traded companies and rated on a scale

from 1 to 99, with 99 being best. An EPS Rating of 99 means a company

has outperformed 99% of all other companies in terms of both annual

and recent quarterly earnings performance.

Other notes;

You should never get discouraged and give up on the

stock market’s potential during intermediate-term sell-offs or short or

prolonged bear markets. America always comes back because of its inventors

and entrepreneurs and the total freedom and unlimited opportunity that do not

exist in communist or dictator-controlled countries

A bear market is the time to do a postanalysis of your prior decisions. Plot

on daily or weekly charts exactly where you bought and sold all the stocks

you traded in the past year. Study your decisions and write out some new

rules that will let you avoid the mistakes you made in the past cycle. Then

study several of the biggest winners that you missed or mishandled. Develop

some rules to make sure that you buy the real leaders and handle them right in

the next bull market cycle. They will be there, and this is the time to be

watching for them as they begin to form bases. The question is whether

you

will be there with a carefully thought-through game plan to totally capitalize

on them.