He Knows Investors' Business, Daily: William J. O'Neil

You've been involved with the markets for quite a while. Why the decision to not only participate in the market, but also to educate investors through various media, the best known being Investor's Business Daily? What was the reason behind that?

Investor's Business Daily is a great product, and it was created to help people. It gives them information, facts, and figures that they've never been able to get before. Most newspapers, including The Wall Street Journal, take the Associated Press tables that include high, low, close, and so forth, and just put them in without any real thought involved. At IBD, we calculate whether a stock is under accumulation, the relative strength of the industry group, the earnings per share growth rate, the relative price action, sponsorship ratings -- all sorts of vital measurements you can't find anywhere else. Thousands have benefited greatly from it.

When you started IBD, was there a sense that some of the things that were out there just weren't providing the information that investors could pick up, study, and apply?

Absolutely. Before, some of my top people at O'Neil + Co. were saying that there wasn't anything out there that could help investors select stocks or make money in the market. Since O'Neil + Co., an institutional research firm that has been in business for 35 years, did business with Morgan Bank, AIM Funds, Fidelity, and all the major institutions, we had an immense database with unique research. We had a lot of data and the experience to extract relevant information from the data -- something the public had never been able to really benefit from. So we put that unique data in IBD. It's really accessible, but you have to study it to understand what's there and how to use it.

In terms of picking up a daily financial publication and being able to apply what's there, IBD seems to have a significant, easily accessible presence.

Yes, it is computerized research in print. It goes beyond reading figures. You have to understand what Earnings Per Share and Relative Price Strength Ratings are and how to use them. But we've done all the historical tests and so we don't put anything in our stock tables until we know it works.

For example?

When we assign a Relative Price Strength Rating to each stock in our tables, we know, based on our models, that every year for the past 50 years all the outstanding stocks averaged a relative strength of 87 before they took off and had a major move. This 87 is a relative measure between one and 99, with 99 being the highest. That means in the prior year this stock outperformed 87% of all other stocks and shows potential. That's why we put Relative Price Strength in there. We've tested it, we've measured it, we know where the cut-off points are. We tell people not to mess around and buy anything unless it shows a Relative Price Strength Rating of at least 80. They're probably better off with ones that are 90 or higher. [Editor's note: In this definition of relative strength, from IBD: "Relative Price Strength (RS) Rating measures a stock's relative price change in the last 12 months compared with all other stocks. Results are on the same simple 1-99 scale. Better companies have both an earnings per share and relative strength rating of 80 or higher."]

Have there been any changes in either market behavior or the way people invest since you have been involved with the markets?

There hasn't been as much of a change as people think. Of course, the markets are much bigger, and mutual funds have grown to mammoth size. This has put billions of dollars into the markets. Because of the vast sums available to be invested through funds, a trend developed toward bigger-cap stocks several years ago. But what makes stocks go up or down is pretty much the same, and so is human nature. Those don't change.

Even though there are more people investing in the market these days, they still don't determine stock prices. You get more volatility, as we've seen when we had the high-tech boom, but the basic characteristics are still the same as they were 20 or 30 years ago. It's still the major institutions that determine the price of stocks. They're the big source of supply or demand. For example, if a company introduces a new product that sells well, earnings go up and the charts start to look better. When that happens, the institutions are not going to ignore it. They go in and start buying big quantities and run up the prices.

The CAN SLIM system you developed has gained a lot of attention. From time to time I've heard people say that they liked the system but questioned whether it still works. What's your response?

CAN SLIM still works, and it probably will for many years. The CAN SLIM system is based solely on models of successful stocks and how they've worked each year. We included stocks back to 1953 and the results are similar each year. Stocks show common performance characteristics before they make major price moves. The successful characteristics of these stocks are based on pure market history; those characteristics really haven't changed much over the years. There are still earnings increases, sales increases, profit margins, relative price action, and institutional sponsorships coming in that drive stock prices higher. The basics haven't changed that much.

Unfortunately, many people don't really pay much attention to how the method or approach works. But those who have been following the system for a long time know it works and don't violate it much. They try to stick as closely to it as they can, because it's worked substantially well for them.

One thing that attracted me to CAN SLIM was that it seemed to blend the best of the fundamental and the technical. Was that a purposeful blending, or was that simply the way you look at the market?

We built the models for every stock that had a huge move, and we looked at all the characteristics - fundamental and technical - that were occurring before they took off and went up in price five or 10 times. We found that in virtually every instance, earnings were accelerating and sales were increasing. Not only were these variables accelerating, the stocks were also getting huge volume and good sponsorship, and they were in one of the leading groups. In these outstanding stocks, we found a combination of 10 or 15 technical measurements and 10 or 15 fundamental measurements that coincided.

If you follow the CAN SLIM system, you're investing based on how the market actually works and not what we believe or someone else thinks it ought to be doing. When we were building our models, we found that price/earnings ratios were irrelevant. Everybody on Wall Street operates based on P/E ratios. If a stock has a low P/E ratio, then it's considered a value stock, and if its P/E is too high, the stock is said to be overvalued and you should sell it. Our models show this is not the case. A lot of the stocks started out at 30, 40, 50, or 100 times earnings. Then the P/E ratios expanded by 130% and the stocks had huge moves. If you focus on low P/Es as so many do, you would probably have missed every major stock market winner dating back to 1953! It depends on other variables, such as the acceleration in earnings, sales and profits. We assume the P/E is about where it ought to be at the time. We bought America Online (AOL) at 100 times earnings and sold it when the P/E was 400 times earnings.

Would it be accurate to say that you follow a fairly rigid analytical model?

We study history and facts. We don't listen to analysts or to the opinions of people who say a stock is considered too high, too low, or a great buy. When CISCO started coming down last year, many considered it a great buy and an even better buy whenever it lost an additional 10 points. Anybody who followed that thinking would have lost his shirt. That type of investing is based on personal opinion. It is not based on models that have been built on what actually works in the markets.

The CAN SLIM system works because it has nothing to do with our personal opinions or Wall Street's. We build models each year for every stock that had a 100%, 200%, or 300% advance. We look back over a 50-year period, and for each stock, we study all the characteristics of what each looked like before its huge move. Our models show us that a great leader in a bull market can have a huge advance, but when you are in a bear market, that same stock will be the one that comes down the fastest. We also looked at how those characteristics changed when the stock price started to top. It's all about supply and demand.

How do you determine which stocks are going to be the leaders in a bull market?

In my book 24 Essential Lessons For Investment Success, we have a list of buying rules, which are the same rules that we derived from our models. The studies show that stocks have to have earnings and sales increasing at a certain rate and a return on equity over 17%; they have to be coming out of basing areas on charts, have volume demand, and be a higher-quality institutional-type stock.

More than half of the growth stocks that are true market leaders top with what we refer to as a climax run. When the rate of momentum accelerates so much that it increases the price of a stock as much as 50% in two weeks after many months of increases, that's called a climax top. When we see this happening, we almost always sell the stock.

Two of our holdings, AOL and Charles Schwab (SCH), both topped this way. They ran up seven or eight months and then all of a sudden in a two- or three-week period they took off and ran even faster than before. We made a great deal of money with them because our method involved recognizing companies that have increasing growth in earnings, sales, profit margins, and return on equity. We sold them in early 2000 because our sell signals emerged.

During 1998 and 1999, there was a lot of optimism in the markets. What were your thoughts during that period when things were going up through the roof almost without reason?

You have to remember we were in a technology boom, with the Internet, networking, computers, and all those other technology stocks. There were some dramatic increases in March 2000, and several stocks were topping. We applied our rules based on how the leaders had topped in the past. If we saw a similar pattern emerging, we sold. Market analysis is not about predicting the market or knowing what it's going to do. Market analysis is about following rules based on historical precedent and what you should be looking for to sell a stock. Again, we place an emphasis on history and facts rather than somebody's opinion. In fact, we don't like to hear analysts' opinions, or anybody else's, for that matter. We just want to deal with the facts.

We have to realize there are good periods and there are poor periods. We have to recognize a good period and invest in the best stocks in the best groups, but you also have to recognize the end of the good period, which is when you have to get out of your investments.

Let's talk about charts. You helped introduce the concept of the "cup-and-handle" chart pattern. What are your thoughts on chart patterns and chart reading in general? How can that play into somebody's strategy?

Everyone should learn to read charts. It may take some time, but if you learn how to read them correctly, you can tell how a stock is behaving. In other words, you should be able to recognize if a stock is under accumulationÝ, if professional buying is involved, or if it is under heavy distribution (or selling)Ý. The person who knows how to read a chart can eliminate nine out of 10 stocks that aren't worth looking at and concentrate on the few that show positive characteristics.

What else can you do with chart reading?

You can also significantly improve your timing. There are times when there is a high probability that a stock is going to act the way you want it to and there are other times when you just want to stay away. The person who knows how to read charts has a major advantage.

So you'd call yourself chartists?

No, we're not. We start off by looking at fundamentals such as earnings growth, sales growth, return on equity, and profit margins. We also look to see if the company is in a strong industry group, if there is a new product, if the company is gaining market share, and the quality of the management of the company. Once we identify the strong stocks based on their fundamental criteria, we look at the charts to time our buying or selling. By putting all these things together, your probability of success is far greater. Once you learn all these techniques, you could make 100% or 200% in a a good bull market.  But of course, beginners can't expect to do that.

The "Where The Big Money's Flowing" screen in each issue of IBD refers to a number of factors, but obviously one of the factors it emphasizes is volume. You mentioned institutional buying as a major market-moving factor. How big of a factor is volume in determining stock prices?

Most people look at the price of their stock and don't pay much attention to volume. But volume is a crucial component of the measure of supply and demand. When you have major volume coming into a stock, it tells you there are important players involved. So yes, we look at volume very carefully. It can also tell you when a stock is starting to top.

How?

You have to try to determine the price and volume relationship. When a stock is topping, the volume figures start to get adverse. But in order to see this relation, you have to have models that go back several years and analyze the price-volume relationship during periods when the stock topped. I gave you an example of the climax run, which is the classic way that a lot of them top. When you see this happening, you just have to sell your holdings. But those who are unaware of this climax run or don't use a chart are going to be oblivious to it. They'll get hurt, because almost inevitably those stocks will break down and decline substantially.

Many investors suffered significant losses - 30% or more - when the market fell severely. What type of an exit rule should investors use to protect themselves from these mounting losses?

If people just follow our 8% sell rule, that simple little rule that we've talked about every month for the last 20 years -- if you start off wrong and you're down 8%, then cut it -- they would have saved most of their capital in 2000.

A lot of people lost a lot more than 30%. The reason behind these large losses has to do with the fact that nobody wants to take a loss. It has to do with human nature - denial and hope. It's both emotional and psychological. If the price of a stock they own is down, they're going to hope it will come back. They don't think it's possible for the price to go down a lot lower, because they don't realize how bad it can really get. And as it gets worse and worse, then they really don't want to sell because their losses will be much higher and it'll hurt more.  Human emotions are costly in the stock market.

What happens when their losses get really large, something above 60%?

At that point, some people will panic, sell everything, and never return to the market. They'll say it's not for them, which is really a shame because they're not taking the time to sit down and see what they did wrong. The only way you get better at something is to figure out where you made your mistakes and correct them. You do this by writing some rules for yourself. I would say that after the 2000 experience, most people should plot on charts where they bought and sold each stock and note the ones where they lost money. Start writing better rules and sticking to them. I adhere strictly to the 8% rule. Whenever I'm 8% below the price I paid for something, I will cut my losses. That's the only way I can protect myself against a 50% loss.

Each issue of Investor's Business Daily includes the "10 Secrets To Success." How important is the role of optimism for an investor?

Optimism is important for both your personal life and your business, but I don't think it's important at all in a market. In fact, it could actually be dangerous. You have to be realistic. When things are going your way, they're going your way, and when they're not, they're not. The markets are complex and I don't think optimism is a trait that necessarily helps much in dealing with it. In fact, a lot of people hope and get excited about something when they should recognize that maybe their stock isn't doing well. They should be afraid.

You mentioned the idea of optimism being dangerous in the market. Does that mean that you initially consider all stocks as bad investments?

Yes, unless they go up in price. As far as I'm concerned, there are no good stocks unless they prove they're making money for you. Many people will tell you a stock they own is good and it's doing fine because they're getting a dividend from it. But the price of their stock could be down 20% or 30%. These investors are not being realistic. They are losing their shirts. They made a mistake by investing in the stock and they shouldn't just be saying it's a good stock, because it could go even lower.

So how do you identify companies that have good management, increasing earnings, new products, and so forth?

There will always be companies that are doing well and have good products, but when you're in a bear market, nothing much is going to work because the pressure on the market holds back even the good names.

So what can we do?

We boil it down to something simple. We say there are only three things you have to do in order to be successful in the market. First, you have to find the best stocks in the best groups. Look at the charts of the specific stocks and buy when they're emerging out of bases and beginning a major move. A base is a consolidation area -- anywhere from eight weeks to 15 months in duration -- during which prices are confined to a given price range.

Second, you have to have sell rules that tell you when to sell and take a profit. These sell rules should be based on selling when the stock is either starting to get into trouble, based on cutting losses, or the stock is giving signs of reaching an exhaustion point. The 8% sell rule is key for the latter.

Third, you have to be able to interpret the market. Identify whether the market is in a bullish or bearish mode, or if the stock or market is under distribution. By reading IBD's general market page every day plus "The Big Picture" column that interprets the indexes on a daily basis, investors will be able to stay abreast with what the market's doing and learn how to interpret it, which gives them a heads-up on when to sell.

Many of our in-house money managers in our holding company were invested in Treasury bills from September 2000 all the way through March 2001 because the market's indexes were under distribution and made them nervous. But once the market began to behave in a sound and proper way, it was time for the money managers to go back and start looking for stocks to buy.

Most investors don't utilize these three aspects together. Most only have some idea of how to pick a stock, but they don't have a clue about selling it, which is why they have so much trouble doing it. They have no rules, no procedures, no systems, no methods; they just buy, hope, and assume everything will be okay.

How important are macroeconomic factors such as interest rates and unemployment figures when it comes to selecting individual stocks?

We find that economic statistics have very little to do with the market; remember, the market's discounting and anticipating three, six, or nine months ahead. Generally, the market starts to tank before the economy gets really weak. In the same way, the market starts to recover before the economy starts improving. You can't predict the market using macroeconomic variables. A lot of strategists operate using economic statistics, but our models show otherwise. We feel the market itself predicts the economy of the future, as opposed to the economy predicting the market. Fed actions on interest rates, however, are important.

So what market variables do you look at?

The starting point for interpreting the markets is to determine the market trend. Identify whether the market is in a major uptrend -- a bull phase -- or a major downtrend -- a bear phase. We think the most important variables to track are the broader market averages themselves -- the Dow Jones Industrial Average (DJIA), the Standard & Poor's 500 (S&P), and the Nasdaq. In Investor's Business Daily, on our general market page, we have "The Big Picture" column. It properly called a top in the market back in March 2000 and again in September 2000 based solely on interpreting the market averages.

Second, in terms of trying to interpret the market, you need to see how the leading stocks are behaving. A year ago, in this past bull market cycle, it was the Microsofts, the Ciscos, and the Sun Microsystems that started either to top or have problems. Recognizing this behavior is your next best indicator.

Only after that do we look at interest rates and the Fed funds discount rate. We operate very successfully just by knowing how to analyze the facts and the daily market indexes.

There's a whole chapter in 24 Essential Lessons that tells you how to interpret the key indexes, distribution days, and follow-through days. It's a little complex, but it can save your neck if you learn how to interpret them. Of course, if you don't want to spend the time, you can just read "The Big Picture."

The big picture now is one that many are calling a bear period, although some aren't convinced. What should investors be doing with their money during periods like this?

I wouldn't say this is a bear market. I would say that it has already hit bottom. We came out of a bear market that lasted for a year. It started back in March 2000 and we think it ended in March 2001. All of our signals and indications reflect this. There was a major follow-through day around April 10 of this year, when the market was up several percentage points on increased volume. It was not the first day of a rally but the fourth or fifth day, and it occurred on all the indexes. There were also other follow-through indications several days later. We use this technique to interpret the averages, and it has led us to believe that the new, but slower-moving bull market started on April 10, 2001.

Considering how alarmed everybody is about the market, that's certainly good news.

History shows that during bear market bottoms everybody is scared. The news is always terrible, somebody's going bankrupt, there are problems overseas, there are fears, high-tech business is down, and so on. That's normal and it means the markets again are anticipating. If you look at the charts, you can see that all the indexes had little cup-with-handle patterns. In late April 2001, they were coming out of this pattern and holding tight, but the markets went through a period with severe damage so it'll take time for investors to make any major progress. A lot of fences have to be mended. A lot of these high-tech stocks are still down substantially from their highs. You have to go slow in this market because it's going to take a lot of time for the situation to improve. If you want to select high-quality investments, you've got to know what you're doing.

Like what?

Currently, you don't want to get into the volatile tech sector, because that can be risky. It's more of a patient but positive market, not a bear market.

Obviously, IBD and your website, investors.com, have done a lot to provide individuals with good advice and information. But what keeps those who are in the position to invest in the markets from doing so?

I think most of it has to do with fear and lack of self-confidence. They probably hear last year's horror stories of people who have lost a lot of money, so they get scared. And in a way they have a right to be, because if you don't know what you're doing, you can get into problems. A lot of people lost money last year. But if they're willing to sit down, read, and study, they can make superior investments because the information is available.

At IBD we provide CD-Roms, and we offer classes, booklets, and materials. I have two books out that if people are willing to read, they can use the information there to their advantage. It's their money and they should want to learn what to do with it. There are thousands of people who have made quite a bit of money by just studying and learning our materials. But you have to put your mind to it.

RELATED READING AND REFERENCE

O'Neil, William J. [1995]. How To Make Money In Stocks, 2nd ed., McGraw-Hill.
_____ [2000]. 24 Essential Lessons For Investment Success, McGraw-Hill.
www.investors.com

CAN SLIM

Called "a winning system in good times or bad," William O'Neil's Can slim strategy for investing has helped thousands of stock investors and traders optimize their performance in the marketplace. Here is a brief outline of Can slim, as introduced in O'Neil's How To Make Money In Stocks, with explanatory quotes from O'Neil himself.

Can slim is an easy-to-remember acronym that William O'Neil has created in order to help stock investors remember what is most important when looking for winning stocks in which to invest. O'Neil refers to all stocks as "bad" until they go up, so his Can slim method throws down the gauntlet when it comes to assessing stocks for future growth. Can slim stands for:

C: Current quarterly earnings per share: How much is enough?

O'Neil: "The common stocks you select for purchase should show a major percentage increase in the current quarterly earnings per share (the most recently reported quarter) when compared to the prior year's same quarter."

A: Annual earnings increases: Look for meaningful growth.

O'Neil: "Each year's annual earnings per share for the last five years should show an increase over the prior year's earnings."

N: New products, new management, new highs: Buying at the right time.

O'Neil: "Search for corporations that have a key new product or service, new management, or change in conditions in their industry."

S: Supply and demand: Small capitalization plus volume demand.

O'Neil: "The law of supply and demand is more important than all the analyst opinions on Wall Street."

L: Leader or laggard: Which is your stock?

O'Neil: "It seldom pays to invest in laggard performing stocks even if they look tantalizingly cheap. Look for the market leader."

I: Institutional sponsorship: A little goes a long way.

O'Neil: "Your task, then, is to weed through and separate the intelligent, highly informed institutional buying from the poor, faulty buying."

M: Market direction: How to determine it?

O'Neil: "The best way to determine the direction of the market is to follow and understand every day what the general market averages price and volume are doing."

-D.P.

Past articles from Working Money, The Investors' Magazine, can be found at Working-Money.com.

Copyright © 2001 Technical Analysis, Inc. All rights reserved.