Every successful trader and investor has a system they follow. It might be something they created themselves, drew inspiration from others for, or just flat out followed another successful trader’s approach.
These systems are important, because they ensure traders are working within an analysis based framework so that as markets move up and down, they’re not reacting emotionally.
Fundamental aspects of a trader’s system will be to know which stocks are bought and sold, what are the entry and exit criteria, how long are positions held for, when do you take losses, how far should profits run and what are your portfolio risk management strategies. Without answers to these questions, traders will be at very high risk of being driven by emotional decision making.
If you don’t have a system yet, or don’t know where to start in creating your own system, one of the best places to begin is by looking at the CAN SLIM method.
The CAN SLIM Method
The CAN SLIM method is a trading strategy that aims to discover growth stocks that have strong price momentum and come with solid fundamentals.
The CAN SLIM method was created by William O’Neill, the co-founder of Investor’s Business Daily. As a former stockbroker and author, he analysed the best performing stocks from the 1880s to 2009. The results of his analysis pointed to a number of features that top performing stocks shared in common, which formed the basis of the CAN SLIM method.
Readers should note that the CAN SLIM method is not a holistic trading strategy – it doesn’t cover how to enter or exit a trade. To get the most out of it you’ll need to combine it with a separate entry and exit strategy, which will be covered in a future article.
The method has a strange sounding name because CAN SLIM is actually an acronym for the key features that William found were common to the best performing stocks. They are:
C: Current Quarterly Earnings
When William concluded his analysis, he discovered that most of the top performing stocks had a quarterly earnings growth of 70% prior to any major increases in price. As a result, quarterly earnings growth is a key emphasis in this strategy.
Secondary to earnings growth, was to observe sales growth, since sales tended to drive earnings. As a result of these two factors, William recommends that the minimum filter should be companies with at least 30% quarterly earnings growth and 25% sales growth.
This approach will filter out large, old companies that while generating steady cashflow, are unlikely to have large spurts of growth and in turn, large changes in price.
A: Annual Earnings Growth
The trouble with just using quarterly earnings in isolation, is that you might get a sharp increase in one particular quarter as a result of cost cutting activities such as selling assets or firing staff. While this provides a great short-term boost to earnings, the long term implications could be worse.
For example, a business cutting its sales team by 50% might save a lot on labour costs, but over the long term they won’t have as many people available to help push the product out to customers.
To combat this, William recommends reviewing annual earnings growth as a way of gaining insight into a company’s longer term potential. As a requirement, William recommends only looking at companies with a minimum 25% annual earnings growth.
N: New Product, Service, Management, Price Breakout
Insanity is jokingly defined as doing the same thing over and over again while expecting a different result. If a company doesn’t make any major changes, it’s relatively safe to assume there won’t be major changes to the stock price either. Instead, you’ll keep getting the same sort of results you always have.
As we’re seeking earnings growth, we want to find companies that are innovating, creating new products and services, or even simply changing management to get a fresh perspective on operations and opportunities.
Sometimes, even a price breakout may be sufficient. It could be that the company has been flying under the radar for a while and is only just grabbing the attention of investors.
S: Supply and Demand
With this feature, William recommends that traders only look at stocks with a small amount of shares outstanding. Simply put, the focus should be on companies where there is high trading volume and a limited number of shares outstanding – meaning demand is greater than supply.
Due to this, William recommends traders focus on small cap stocks when applying the CAN SLIM method.
L: Leader
In William’s analysis, the best performing stocks were leaders in their industry or sector when looking at price performance. He recommends sticking to companies where the relative price strength rating (RPSR) outperforms 80% of the market across a 52 week period.
I: Institutional Sponsorship
When hedge funds, pension funds and large stock market investors are buying up a company, it’s a good sign you might be onto a winner. These types of large investors are called Institutional Investors, which William recommends looking for when buying into a company.
Given their size, Institutional investors rarely can buy into a company during one day and so they spread their purchases over days, weeks and even months. Keeping an eye on this sort of buying pattern will help identify if the big boys are as interested in a company as you are.
M: Market Direction
William defines market direction in accordance with three key types:
- A confirmed uptrend
- A confirmed downtrend
- An uptrend that is under pressure
There is an old saying in investing circles, “the trend is your friend,” and with CAN SLIM this is no exception. Stocks tend to go with the flow of the prevailing market trend, so William suggests buying when a confirmed uptrend is taking place.
Conclusion
First created by William O’Neill, the CAN SLIM method is a trading strategy based on the analysis of the top performing stocks between 1880 and 2008.
By applying a few simple checks, investors can filter out companies that are likely to be low/poor performers and have a concentrated portfolio of companies that based on repeating trends throughout history, are likely to perform well in the coming years.
The strategy isn’t entirely holistic, as it doesn’t define entry and exit criteria. While a future article will cover this topic, traders can explore using the Institutional Sponsorship and Market Direction criteria as a potential filter in this regard.
Trade safe!
Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.
