The CANSLIM approach

William O'Neil was an American stock broker, founder of Market smith and a very successful trader. He became popular for the invention of the CANSLIM approach where he combined technicals and fundamentals to beat the market by a wide margins. This blog will aim to discuss and explain the CANSLIM approach in detail.

disclaimer: most of the opinions are of William O'Neil which I have read and taken from his books. I will explicitly mention 'I' when I give my opinion.

C: Current big or Accelerating quarterly earnings per share.

Explosive stock moves follow explosive earnings. O'Neil says that even an 8-10% increase in EPS should not be enough to move the needle; the growth has to be explosive! I would suggest looking for businesses displaying a minimum increase of 30-35%. EPS is the single most important metric to determine a business's trajectory. Even a value buy is only if the growth resumes or increases.

Omit the one-time gains

Investors should not be influenced or atrracted to non recurring revenue. A non recurring revenue could be something like sale of real estate, in such a case the investors should subtract this income and find the modified or actual core business eps. 

Look for big old companies with maintenance management.

Many 'big old' companies have mediocre management, leading to lackluster earnings. In contrast, true growth companies are characterized by an excellent product portfolio and, crucially, excellent management. Identifying such management is a key factor in evaluating a business's potential for growth and success.

Look for accelerating quarterly earning growth

This is very important. Look for businesses that are increasing their growth rates. An example could be a growth rate of 30% went to 35% and then 40%. That is exactly what we need to find and hold on to. These are considered earnings surprises where a slow grower shows exponential growth, which generally leads to PEAD: Post earnings announcement drifts. A problem that I have encountered is looking for accelerating businesses means that you will probably pay a premium for it. Instead, I prefer buying businesses based on superior earnings growth and doubling down on those that show acceleration.

Compare with peers

Most of the moves are group moves, this applies to stock prices but more importantly earning movement. Cycles play a big part in determining the next winner. Which is why, we should compare businesses of the same sector( when the whole sector is showing great eps share) and pick out the best ones.

A: Annual earnings increase

Quarterly earnings are great, but they aren't enough. We need to look at the bigger picture to ensure that this is not just a flash in the pan. We need a high-quality company and hence require more proof to judge it. 

Select stocks with 25-50% annual growth rate.

Data studied by William O'Neil between 1980 to 2000 showed that some of his biggest winners had a median growth rate of 36%. We need businesses that have the calibre to grow, if they grow then only can the our capital grow. As simple as that.

Look for BIG ROE

According to O'Neil, two other profitiability metrics that need to be taken seriously are cash flow per share and ROE. ROE, calculated by dividing net income by shreholder's equity, is a key indicator of a company's efficiency. The more efficiently a company is run, the higher its valuation. O'Neil's research shows that the most successful companies had a ROE of at least 17% (the higher, the better).

The greater the cash flow per share, the better. Look for businesses where the cash flow is outpacing the actual earnings.

Check the stability of a company's three year earning record.

The stability and consistency of earning growth matters. O'Neil did a study where the consistency of earnings was rated from 1 to 99, where one is very stable and 99 is not. It concluded that the higher the stability of earnings, the better it is.

Growth stocks with a steady earning trend are below 25 and the businesses above 30 could signal cyclicality.

Weeding out losers

Emphasis on a good 3-year track record will weed out 80% of the stocks. An Annual growth record does not mean it is a growth stock. Many businesses growing at 30% which fell to 10-15% are regarded as matured growth stock. We need to find the outliers who consistently exhibit great records. 

We need to insist on quarterly and annual earning growth being excellent.

Are Price/earning really important?

According to the work done by William O'Neil, he concluded that PE do not hold a substantial relevance in determining the biggest winners. Collecting the biggest winners from 1880 to 2009 in the US stock market, it was observed that the best perforing businesses had an average of 20 PE, which would expand to the ranges of 45-60. From 1990 to 1995, real leaders had an average PE of 26 which would expand to 60-115. These multiples would go to unimaginable multiples during bull markets.

Their studies suggest that PE ratios are an end effect of accelerating earnings, which attracts institutional buyers and ends up resulting in substantial price appreciation. In a roaring bull market, do not avoid high PE stocks, as these could be the following big winners.

I understand Mr. O'Neil's point of view. Buying these businesses at 40 times earnings or 70 for the leaders would still yield great results. However, as a primary investor, starting multiples matters quite a lot. I reason that by buying a very high PE stock, I reduce the returns I can make from multiple expansions as there is a specific cap to it (most of the time), and I also open myself to the risk of severe derating when earnings falter. What matters the most is the PEG ratio. A 20% grower at 50 PE is not refined, but a 50% grower at 50 PE is fine.

N: Newer companies, new products, new management, new highs of properly formed chart bases.

What really leads to the explosive earnings growth? it is a catalyst that leads to the increase in rate of change of the business performance and eventually the stock price performance. Apart from these new factors mentioned above, a new change in industry such as supply shortages, price increases, or the introduction of a revolutionary technology can also have a positive effect on most stocks in an industry group.

In their study of the greatest stock market winners, 95% of the businesses fell into one of these categories. That is too strong of a data point to ignore.

Stock market's great paradox

Many believe that buying businesses on their 52-week low are bargains and will yield good, safe results. A study conducted by O'Neil showed that this is not true at all. The strategy of buy low and sell high is flawed

. The paradox is: what is high will go higher and what is low will go lower. What we can infur from this is that we need businesses that show a change, a catalyst in them if we are risking to buy at low, which they generally fail to do.

However, that does not mean buying them at their high is also right. We need to use stock price charts to find the right time to buy. O'neil in his book, How to make money in stocks shows a 100 charts that showed similar trends which support CANSLIM. According to that, we should search for companies tha have developed new products or services, or that have benefitted from new management or materially improved industry conditions. Then buy their stocks when they are emerging from a sound, correctly analysed price consolidation and are closer to or making a new price high or increased volumes.

S: Supply and demand: big volumes at key points

The price of everything is a function of its supply and demand. Why have we faced issues with the rising tomato or onion prices? because there was a shortage. Why are businesses like trent trading at such high multiples? because they are great businesses so everyone wants it, hence a higher demand for a limited supply. We need to use this to find the right stocks and entry points to maximise gains.

Big or small supply of stock

It's important to understand the concept of low float stocks. These are stocks with a relatively small number of shares available for trading, making them more susceptible to price volatility. For instance, it's difficult to significantly impact the value of a stock with a floating market cap of 1L crores. However, a stock with a floating market cap of a few hundred crores can be more easily influenced. This is the essence of low float stocks.

Low float stocks and earnings growth are a recipe for exceptional gains. Many people want this stock, but the supply is limited. There can be a potential problem where mutual funds are very big and have market cap constraints, where they are forced to buy big businesses as the small ones are impossible to make a meaningful return. One thing to note is that low float allows ferocious price appreciation but can also be equal, if not more, when the stock price corrects. Hence, trade with caution.

The best way to measure supply and demand is to look at daily volumes. When a stock price is corrected, you want to see the volumes dry up and expand significantly when a run-up occurs. Moreover, volumes should generally increase by 40-50% when a stock gets out of consolidation. It might even be 100% in many cases, which signifies strong buying.

Look for buybacks and insider buying

Buybacks and insider buying have a few key roles to play. Buybacks mean that the shares will retire and hence the EPS will increase. Insider buying will mean that the promoters are confident of the business. A shared advantage is that the supply of shares is reduced. the Floating market cap decreases which means that the demand increases with respect to the supply.

Any stock can be bought using the CANSLIM approach, its just that the small cap stocks will be a lot more volatile and hence show greater appreciation/depreciation in the same amount of time.

L: Leader or laggard: which is your stock?

Look for businesses that are the top 3 in their industry group. These businesses, during an up cycle will show great price appreciation. An example that i can think of is hotels or cables. EIH, IHCL, KEI cables and Polycab have been the industry leaders and have delivered great returns over the past few years. Another example that I can think of is real estate where businesses like Prestige and Godrej Properties have performed very well.

There is a reason these businesses are leaders in their industries, and hence will outperform the peers. Do not get fazed by their multiples. All that is needed is earnings.

How to separate leaders from laggards?

Sell the worst performers first and keep the best a little longer. The fastest and easiest way to track leaders is using RS or Relative strength. Using Market smith India can be very helpful to track this. A rule of thumb is that any stock below the rating of 70 is a laggard. Do check out the website to understand this. from the early 1950s to 2008, the average RS rating of the best performing stocks before their major run ups was 87! In other words, best stocks were already doing better than 9 out of the 10 stocks before they started out to explosively advance. Look for genuine leaders and avoid laggards.

Finding new leaders during a market corrections

Corrections can help you identify the next new leaders. The more desirable growth stocks will correct 1.5 to 2.5 times more than the general market averages. For example, a 10% correction at market level will lead to 15 to 25% correction in the growth stock. However, a stock that slides to 35-40% correction during a 10% market correction is a warning signal and is better if avoided. Once the general market decline is over, the first ones to recover are the genuine leaders who tend to break their highs week by week for about 13 weeks straight.

I: Institutional sponsorship

Institutional sponsorship refers to the stocks that institutions own. Research reports, recommendations, etc., should not be considered sponsorships. It means institutions are buying the business. According to O'Neil, it is preferred that these institutions have some ownership. Twenty institutions is a reasonable amount( we should reduce this number in the context of the Indian stock market, as it's not as wide as the American one). If a stock has no institutional ownership, it means that 100s of them probably passed it.

In my view, while it may hold true for larger businesses, the dynamics change when it comes to small caps and microcaps. These smaller companies often face institutional constraints, making it challenging for them to attract institutional ownership. Therefore, it's crucial to approach them from a different perspective. For such companies, the emergence of initiating coverage reports is a significant milestone, indicating that the business is gaining recognition. 

Continuing, Look for businesses that show an increasing number of quality buyers(institutions) and new positions being built. This helps filter out most stocks and helps understand where the smart money is flowing. 

However, it's important to be cautious. There are instances where a stock might be overowned by institutions. The risk here is that this could lead to higher or stronger selling volumes when these institutions decide to sell, making it crucial to stay aware of such situations.

M: Market direction: How you can determine it

You can be right about everything discussed above, but if you are wrong about the market direction, 3 of your 4 stocks will plummet along with market averages. Hence, it is a must to have a general sense of understanding of the market direction.

Stages of stock market cycle

It is not possible to know the market cycle accurately; you can only try to be accurate. The key is to understand bull markets and bear markets. Investors should pay particular attention to the recent cycles. It is difficult to crack the end or the beginning of both cycles. There will be multiple fakeouts, pullbacks, shakeouts etc, before the cycle reverses. A simple and reliable way is to use moving averages and use stage analysis to determine the direction of markets. These will help you ride the trend and exit when we see visible signs of reversals.

The myth of long term investing and being fully invested.

Many investors and institutions believe in surviving the thick and thin of the markets. It might even work when bear markets top at 25% decline or so, but not all bear markets are the same. There can be ferocious declines like the 2008 where most of your capital and compounding gains will be wiped out. Not only that, the time it will take to reach that level will be considerable. The strategy should always be buy and monitor as buy and hold is a very inflexible approach and can prove to be disastrous.

Protecting yourself from market downturns

In the stock market, there are the quick and then there are the dead. After you see a few several indications of a market top, do not wait around and sell. O'Neil suggests that we should atleast put 25% in cash when we believe a market top has been formed.

Using Stop loss orders

Using stop loss makes it mechanical that you will be out of most of your stocks during a decline. It is better to not place limit orders but instead monitor closely and sell when it approaches towards your stop loss. Do not fight for 1/8 of a rupee or something, understand the direction and act accordingly.

How you can learn to identify stock market tops

To detect the top, track the top indices such as Nifty 50, Sensex, midcap and smallcap index. On one of the days of the uptrend, volumes for the market will increase from the day before, but the index itself will show stalling action. Ordinary liquidation near the peak usually occurs on three to six specific days or 3-4 weeks. Meaning that the market comes under distribution when the markets are advancing! This is because a few people have started to recognise the overextension of the markets and have started covering their positions. Sometimes, the distribution might take longer, but it leads to a decline in the coming weeks. After the first decline, the markets will either have a poor rally, leading to rally failure, or a positive follow-through, which is the beginning of a bull rally. 

The book suggests we should analyse the bull market tops of the past and try to find similarities to avoid being a part of the fall in the following top. 

A big help will be following the market leaders. We can be fairly certain if the leaders start acting abnormally after the market has advanced for the past few years. One example is when stocks break their 3 or 4th base to rally, even after incorrect faulty bases.

This marks the end of the CANSLIM approach. It is a comprehensive strategy that weeds out most of the businesses and takes only the best. It is a great combination of technicals and fundamentals as the businesses are picked by fundamentals and ideal entry point is determined by the technicals. I would highly suggest all to read the book "How to make money in stocks" by William O'Neil as it gets into the details of this strategy, analyses 100s of charts and entry exit points. It is a very helpful book

I hope you all learnt and enjoyed from this blog.