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    How to Use the CAN SLIM Approach to Screen for Growth Stocks

    by John Bajkowski

    How To Use The CAN SLIM Approach To Screen For Growth Stocks Splash image

    Take an attention-grabbing book title, toss in an easy-to-remember acronym, and top it off with a daily business newspaper that supplies information required for preliminary analysis: You’ve got the recipe for a popular investment strategy. The CAN SLIM approach is presented by William O’Neil, publisher of Investor’s Business Daily, in his book titled “How to Make Money in Stocks: A Winning System in Good Times or Bad.”

    The second edition of “How to Make Money in Stocks” presented a stock selection approach developed by studying 500 of the biggest stock market winners from 1953 to 1993. The CAN SLIM approach presented in the book was based upon the characteristics that these winning stocks possessed prior to their big price run-ups. Recently, O’Neil extended his analysis of past market winners to 600 companies that performed strongly from 1953 to 2001 and revised a number of CAN SLIM criteria. The third edition of “How to Make Money in Stocks” was published last year and presents the revised CAN SLIM rules (see Table 1). This article presents the CAN SLIM approach with an eye toward the recent changes and its application using AAII’s stock screening system—Stock Investor Pro. Additionally, the March/April 2003 issue of Computerized Investing presents how to apply the CAN SLIM stock screen using Internet stock screening systems.

    CAN SLIM Overview

    The CAN SLIM approach seeks companies with a proven record of quarterly and annual earnings and sales growth showing strong relative price strength and support from leading institutions. O’Neil does not mind paying rich premiums for stocks with good prospects. He feels that most strategies seeking stocks with low price-earnings are flawed because they ignore the price trend determining the price-earnings ratio, as well as the quality of the underlying earnings within the ratio. O’Neil believes that stocks generally sell for what they are worth and most stocks with low price-earnings ratios are probably priced correctly by the market. O’Neil also asserts that it is important to follow the market closely and try to lighten up your stock exposure when going into a bear market.

    C = Current Quarterly Earnings

    The CAN SLIM approach focuses on companies with proven records of earnings growth that are still in a stage of earnings acceleration. O’Neil’s study of winning stocks revealed that these securities generally had strong quarterly earnings per share performance prior to their significant price run ups.

    O’Neil recommends looking for stocks with a minimum increase in quarterly earnings of 18% to 20% over the same quarterly period one year ago. When screening for quarterly earnings increases, it is important to compare a quarter to the equivalent quarter last year—in other words, this year’s second quarter compared to last year’s second quarter. Many firms have seasonal patterns to their earnings, and comparing similar quarters helps to take this into account.

    Another item to watch for when screening for percentage changes is a meaningless figure created by having a very small base number. For example, an increase from one penny to 10 cents translates into a 900% earnings increase. It is always advisable to look at the raw numbers of the company passing the screen. This allows you to gauge the overall trend and stability in earnings and other items such as sales and cash flow.

    Whenever you are working with earnings, the issue of how to handle extraordinary earnings comes into play. One-time events can distort the actual trend in earnings and make the company performance look better or worse than a comparison against a firm without special charges. O’Neil recommends excluding these non-recurring items from the analysis.

    The first two screens require quarterly earnings growth greater than or equal to 20% and positive earnings per share from continuing operations for the current quarter. We used Stock Investor Pro, with data as of March 14, 2003, for the screen. Only 2,343 stocks out of an initial universe of 8,428 met these two criteria. Beyond looking for strong quarterly growth, O’Neil likes to see an increasing rate of growth. An increasing rate of growth in quarterly earnings per share is so important in the CAN SLIM system that O’Neil warns shareholders to consider selling holdings of companies that show a slowing rate of growth for two quarters in row. The next screen specified that the earnings growth rate from the quarter one year ago compared to the latest quarter be higher than a similar quarter one year earlier. This reduced the number of passing companies to 1,556.

    As a confirmation of the quarterly earnings screen, O’Neil likes to see same-quarter growth in sales greater than 25% or at least accelerating over the last three quarters. This new screening requirement was added to the third edition of O’Neil’s book and seeks to help confirm the quality of a firm’s earnings. Independently, 3,647 stocks have a current quarterly sales growth greater than or equal to 25%, but combined with the other filters the number of passing companies was reduced to 393.

    The CAN SLIM system is not purely mechanical and O’Neil also likes to find at least one other stock in the same industry group that shows strong quarterly earnings growth as confirmation that the industry is strong.

    TABLE 1.
    CLICK ON IMAGE TO
    SEE FULL SIZE.

    A = Annual Earnings Increase

    Winning stocks in O’Neil’s study had a steady and significant record of annual earnings in addition to a strong record of current earnings. O’Neil’s primary screen for annual earning increases requires that earnings per share show an increase in each of the last three years. This filter has been loosened slightly from the prior edition, which required earnings increases over each of the last five years.

    In applying this screen in Stock Investor Pro, we specified that earnings per share from continuing operations be higher for each year when compared against the previous year. To help guard against any recent reversal in trend, a criterion was included requiring that earnings over the last 12 months be greater than or equal to earnings from the latest fiscal year. When screened by itself, 795 companies passed this filter compared to the 469 companies that passed the second edition’s tighter filter. Adding the filter requiring a year-by-year earnings increase for each of the last three years to the current growth filters reduced the passing number of companies to just 60 stocks. This is not surprising given the economic environment over the last few years.

    O’Neil also recommends screening for companies showing a strong annual growth rate of 25% over the last three years. This filter only cut an additional six stocks, which is to be expected given the strict consistent year-by-year growth requirement.

    Optimally, the consensus earnings estimate for the next year should be higher than the latest reported year. Adding this filter reduced the number of passing companies to 39. When working with consensus earnings estimates it is important to remember that only the larger and more active firms will have analysts tracking them and providing estimates. About half of the stocks in Stock Investor Pro have consensus earnings estimates, so this filter will also tend to screen out micro-cap stocks.

    Another potential addition to the CAN SLIM screen is a requirement for high return on equity (ROE: net income divided by shareholder’s equity). O’Neil’s studies showed that the greatest winning stocks had ROEs of at least 17%. O’Neil uses this measure to separate well-managed companies from poorly managed ones. Adding this filter would have reduced the number of passing companies to 19 from 39. Our testing over the last five years revealed that this requirement often led to a very small number of passing stocks and hurt performance since 2001. The revised screen does not make use of the return on equity filter.

    N = New Products, New Management, New Highs

    O’Neil feels that a stock needs a catalyst to start a strong price advance. In his study of winning stocks, he found that 95% of the winning stocks had some sort of fundamental spark to push the company ahead of the pack. This catalyst can be a new product or service, a new management team employed after a period of lackluster performance, or even a structural change in a company’s industry—such as a new technology.

    These are very qualitative factors that do not lend themselves easily to screening. A second consideration that O’Neil emphasizes is that investors should pursue stocks showing strong upward price movement. O’Neil says that stocks that seem too high-priced and risky most often go even higher, while stocks that seem cheap often go even lower. Stocks that are making the new high list while accompanied by a big increase in volume might be prospects worth checking. A stock making a new high after undergoing a period of price correction and consolidation is especially interesting.

    O’Neil’s newspaper, Investor’s Business Daily, highlights stocks within 10% of their 52-week high and this was the criterion established for the screen. One would expect many companies to pass during a strong market expansion, while a smaller number of companies would pass during a declining market. Given the weak market during the first few months of 2003, it is not surprising that adding this filter reduced the number of passing companies from 39 to four. As of March 14, 2003, a total of 1,037 stocks out of a universe of 8,428 were trading within 10% of their 52-week high.

    S = Supply and Demand

    O’Neil emphasized smaller-capitalization stocks more strongly in his earlier editions. The third edition states that any size stock can be purchased using the CAN SLIM approach, but smaller companies will be more volatile with greater pop to the upside and downside. Companies buying back their stock on the open market are preferred, as well as companies with management stock ownership. No definitive screens now come out of the S element of the CAN SLIM system, but Table 1 identifies a number of factors to consider when analyzing passing companies.

    L = Leader or Laggard

    O’Neil is not a patient value investor looking for out-of-favor companies and willing to wait for the market to come around to his viewpoint. Rather, he prefers to identify rapidly growing companies that are market leaders in rapidly expanding industries. O’Neil advocates buying among the best two or three stocks in a group. He feels that you will be compensated for any premium you pay for these leaders with significantly higher rates of return.

    O’Neil suggests using relative strength to identify market leaders. Relative strength compares the performance of a stock relative to the market as a whole. Relative strength is reported in many ways and you must be careful to understand how the relative strength figure is used in a given screening system. Companies are often ranked by their price performance for a given period of time and their percentage ranking among all stocks is calculated to show the relative position against other stocks. Investor’s Business Daily presents the percentage ranking of stocks and O’Neil recommends avoiding any stock with relative strength rank below 70% and only seeking out stocks with a percentage rank of 80% or better—stocks that have performed better than 80% of all stocks. While only about 1,680 firms (8,428 × 20%) have a 52-week relative strength rank of 80% or greater, this filter did not further reduce the number of passing companies. In the market environment at the time of the screen, the price as a percent of 52-week high proved to be a more stringent price strength screen.

    I = Institutional Sponsorship

    O’Neil feels that a stock needs a few institutional sponsors for it to show above-market performance. Ten institutional owners is suggested as a reasonable minimum number. This number refers to actual institutional owners of the common stock, not institutional analysts tracking and providing earnings estimates on stocks.

    Beyond looking for a minimum number of institutional owners, O’Neil suggests that investors study the recent record of the institutions. The analysis of the holdings of successful mutual funds represents a good resource for the individual investor because of the widely distributed information on mutual funds. Web sites such as Morningstar.com (www.morningstar.com) and CNBC on MSN Money (moneycentral.msn.com/investor) disclose the top mutual funds that own a given stock.

    The next filter required a minimum of 10 institutional shareholders. About 5,500 stocks pass this filter independently. Adding it to the CAN SLIM filter in Stock Investor Pro did not cut any additional stocks.

    O’Neil also likes to see the number of institutional shareholders increasing for a given stock in the most recent quarters. Stock Investor Pro does not report the number of institutional shareholders over time, but it does report on number of shares sold and purchased by institutions over the last quarter. Our last filter specified that the number of shares purchased should be greater than or equal to the number of shares sold by institutions over the last quarter. This filter did not further reduce the number of passing stocks, which are shown in Table 2.

    M = Market Decision

    The final aspect of the CAN SLIM system looks at the overall market direction. While it does not impact the selection of specific stocks, the trend of the overall market will have a tremendous impact on the performance of your portfolio. O’Neil tends to focus on technical measures when determining the overall direction of the marketplace. Any good technical program or Web site, or even Investor’s Business Daily, should provide you with the necessary tools to study market movement.

    O’Neil finds it difficult to fight the trend, so it is important to determine if you are in a bull or bear market. Table 1 summarizes the type of factors that O’Neil considers when trying to gauge market strength.

    Screening Results

    Table 2 displays the companies passing the CAN SLIM screen based upon our interpretation of the rules presented in both the third and the second editions of O’Neil’s book.

    Figure 1.
    CLICK ON IMAGE TO
    SEE FULL SIZE.

    Four stocks passed the third edition screen compared to the two passing the second edition screen. This is actually a reversal of the normal pattern. We have backtested the revised third edition screen and have found that, on average, five stocks passed this screen every month compared to 12 stocks passing the second edition screen on a monthly basis from December 1997 through March 2003. As many as 32 stocks have passed the second edition screen, while the greatest number of stocks passing the third edition screen was 15 over this time period. On three occasions, no stocks passed the third edition screen, while as little as one stock has passed the second edition screen.

    Although it is difficult to draw conclusions with such a small sample, the stocks passing the third edition screen tend to be larger companies held by more institutional owners, with stronger quarterly earnings and sales growth as well as stronger historical and expected annual earnings growth.

    We have been testing the performance of a wide range of screening systems for over five years now and our interpretation of the CAN SLIM approach has proven to be one of the most consistent and strongest-performing screens during both bull and bear markets. Figure 1 provides a quick view of the initial testing of the revised CAN SLIM approach. The revised approach has proven to be a bit more volatile—rising higher and faster in the bull market of the late 1990s but then giving up its lead in the recent bear market. Both strategies will be tracked and reported on the in the Stock Screens area of AAII.com as well as the semiannual review of strategies in the AAII Journal.

    Conclusion

    The CAN SLIM system has great appeal to the active investor looking for growth stocks. While the approach is specific, it also stresses the art of investing when interpreting the direction of the market. Here we have touched upon CAN SLIM rules helpful in identifying promising stocks. It is important to keep in mind that ideas from a computer screen merely represent a starting point that requires further analysis before action.


     


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