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Summary of presentation by Robert Rossetti
William O’Neil’s CANSLIM stock selection methodology is very well known and widely followed by readers of Investor’s Business Daily. Bob has employed this strategy since the early 1970’s and provided Seminar attendees with unique insights into using this technique.
Bob began his presentation with a short summary of CANSLIM:
C = Current earnings per share should be up 25% or more and in many cases accelerating in recent quarters. Quarterly sales should also be up 25% or more or accelerating over prior quarters.
A = Annual earnings should be up 25% or more in each of the last three years. Annual return on equity should be 17% or more.
N = A company should have a new product or service that’s fueling earnings growth. The stock should be emerging from a proper chart pattern and about to make a new high in price.
S = Supply and demand. Shares outstanding can be large or small, but trading volume should be big as the stock price increases.
L = Leader or Laggard? Buy the leading stock in an industry. A stock’s Relative Strength Rating should be 80 or higher.
I = Institutional sponsorship should be increasing. Invest in stocks showing increasing ownership by mutual funds in recent quarters.
M = The market indexes, the Dow, S&P 500 and NASDAQ, should be in a confirmed up trend since three out of four stocks follow the market’s overall trend.
Under Current earnings and Annual earnings are two recent additions to the rules. Bob noted that requiring quarterly sales to be up 25% or more or accelerating over prior quarters and annual return on equity (ROE) to be at
least 17% will prevent traders from buying into a mania. History has shown that in the late stages of a bull market, companies often pay a high price for acquisitions and lower their ROE. These additions to the system reduce risk by ensuring the companies have solid business plans.
He also expanded on the “M” by noting that tops are often accompanied by distribution days clusters. These days are a signal of broad selling by mutual funds and other institutions that dominate the daily trading action of the stock market. A distribution day occurs when a key index declines on higher trading volume than the prior session. At bottoms, investors should look for a follow-through day as confirmation that the market is turning higher. According to Investor’s Business daily website, www.investors.com, if a rally is genuine, four to seven days into the advance an index should post a one-day gain of 1% or more on an increase in trading activity over the previous trading day. Follow-throughs after the 10th day indicate that a rally may be weak. According to the website, follow-through days are among the most reliable indicators of a fresh uptrend, claiming that no major uptrend has occurred without one.
Adding detail to the basic rules, Bob offered several insights:
• Price without volume is meaningless data. Breakouts must be confirmed by volume. While a breakout to a new high in price is a significant event, it must be legitimized with a volume spike of at least 50-100% more than the usual volume.
• Relative strength often breaks out to a new high along with price.
• While the cup-and-handle is the classic IBD chart pattern, breakouts from any basing pattern confirmed by volume offer trading opportunities.
• There’s symmetry in the marketplace – the bigger the base, the bigger the potential price move after a breakout.
• Rising from the bottom of the basing pattern to the upper limits of the price range requires a lot of buying power. After the rally from the bottom, weak holders will exit during a consolidation, the handle in a cup-and-handle. It is very important to see a consolidation in the basing pattern.
• Because breakouts tend to run up 20%, it is important to limit buy points to within 5-10% of the breakout price.
• Stocks should be held for a minimum of 8 weeks.
• Traders should pyramid up, and never add to losing positions. Bob follows the O’Neil principle of limiting losses to 8% of the initial buy price.
• Second level breakouts are those which occur after an initial price run-up and subsequent consolidation. These are equivalent to Elliott Wave 3, and offer the greatest potential return to the trader.
• Third and fourth level breakouts have a high degree of failure. A third level breakout can be thought of as a fifth wave in Elliott wave analysis.
Sell side discipline is what separates good investors from average investors, in Bob’s opinion. In addition to the 8% initial stop, Bob sells if the chart indicates a price breakdown, especially when the price action is confirmed by volume. He summarized his sell philosophy with a baseball analogy, “three strikes and you’re out.” Strikes include breaks of long-term trendlines; breakdowns through important support zones; and below the 200-day moving average, especially if the moving average is sloping downward.
Robert Rossetti is a portfolio manager for Morgan Stanley on the Asset Allocation team, focusing on the Total Return Trust.
William O’Neil’s CANSLIM stock selection methodology is very well known and widely followed by readers of Investor’s Business Daily. Bob has employed this strategy since the early 1970’s and provided Seminar attendees with unique insights into using this technique.
Bob began his presentation with a short summary of CANSLIM:
C = Current earnings per share should be up 25% or more and in many cases accelerating in recent quarters. Quarterly sales should also be up 25% or more or accelerating over prior quarters.
A = Annual earnings should be up 25% or more in each of the last three years. Annual return on equity should be 17% or more.
N = A company should have a new product or service that’s fueling earnings growth. The stock should be emerging from a proper chart pattern and about to make a new high in price.
S = Supply and demand. Shares outstanding can be large or small, but trading volume should be big as the stock price increases.
L = Leader or Laggard? Buy the leading stock in an industry. A stock’s Relative Strength Rating should be 80 or higher.
I = Institutional sponsorship should be increasing. Invest in stocks showing increasing ownership by mutual funds in recent quarters.
M = The market indexes, the Dow, S&P 500 and NASDAQ, should be in a confirmed up trend since three out of four stocks follow the market’s overall trend.
Under Current earnings and Annual earnings are two recent additions to the rules. Bob noted that requiring quarterly sales to be up 25% or more or accelerating over prior quarters and annual return on equity (ROE) to be at
least 17% will prevent traders from buying into a mania. History has shown that in the late stages of a bull market, companies often pay a high price for acquisitions and lower their ROE. These additions to the system reduce risk by ensuring the companies have solid business plans.
He also expanded on the “M” by noting that tops are often accompanied by distribution days clusters. These days are a signal of broad selling by mutual funds and other institutions that dominate the daily trading action of the stock market. A distribution day occurs when a key index declines on higher trading volume than the prior session. At bottoms, investors should look for a follow-through day as confirmation that the market is turning higher. According to Investor’s Business daily website, www.investors.com, if a rally is genuine, four to seven days into the advance an index should post a one-day gain of 1% or more on an increase in trading activity over the previous trading day. Follow-throughs after the 10th day indicate that a rally may be weak. According to the website, follow-through days are among the most reliable indicators of a fresh uptrend, claiming that no major uptrend has occurred without one.
Adding detail to the basic rules, Bob offered several insights:
• Price without volume is meaningless data. Breakouts must be confirmed by volume. While a breakout to a new high in price is a significant event, it must be legitimized with a volume spike of at least 50-100% more than the usual volume.
• Relative strength often breaks out to a new high along with price.
• While the cup-and-handle is the classic IBD chart pattern, breakouts from any basing pattern confirmed by volume offer trading opportunities.
• There’s symmetry in the marketplace – the bigger the base, the bigger the potential price move after a breakout.
• Rising from the bottom of the basing pattern to the upper limits of the price range requires a lot of buying power. After the rally from the bottom, weak holders will exit during a consolidation, the handle in a cup-and-handle. It is very important to see a consolidation in the basing pattern.
• Because breakouts tend to run up 20%, it is important to limit buy points to within 5-10% of the breakout price.
• Stocks should be held for a minimum of 8 weeks.
• Traders should pyramid up, and never add to losing positions. Bob follows the O’Neil principle of limiting losses to 8% of the initial buy price.
• Second level breakouts are those which occur after an initial price run-up and subsequent consolidation. These are equivalent to Elliott Wave 3, and offer the greatest potential return to the trader.
• Third and fourth level breakouts have a high degree of failure. A third level breakout can be thought of as a fifth wave in Elliott wave analysis.
Sell side discipline is what separates good investors from average investors, in Bob’s opinion. In addition to the 8% initial stop, Bob sells if the chart indicates a price breakdown, especially when the price action is confirmed by volume. He summarized his sell philosophy with a baseball analogy, “three strikes and you’re out.” Strikes include breaks of long-term trendlines; breakdowns through important support zones; and below the 200-day moving average, especially if the moving average is sloping downward.
Robert Rossetti is a portfolio manager for Morgan Stanley on the Asset Allocation team, focusing on the Total Return Trust.
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