Still Standing

Dismissed by many on Wall Street as a mere momentum investor, Investor's Business Daily founder William O'Neil is still preaching his style of growth known as CANSLIM.

To hear industry types talk about him, it would be easy to think William O'Neil had lost all credibility.

The founder and chairman of Investor's Business Daily rose to securities-guru status in the 1990s with a growth-stock investment strategy that was embraced by legions of do-it-yourself investors. But in the years since, his reputation has declined to the point that the mere mention of his name incites instant disdain among many investment professionals.

“Momentum investing crap” is how one executive at a large brokerage firm described O'Neil's investment approach, and he is hardly alone in this belief.

But the truth is, this disparagement is largely misplaced. O'Neil, a former stockbroker, and his oft-maligned system actually managed to get investors mostly out of stocks in 2000, sparing them from the carnage that followed. Further, he remains popular with investors; his books and newspaper still sell, and his investment seminars remain well attended.

A Big Target

So why is so much bile spewed in his direction? O'Neil's missionary-like promotion of his investment strategy (called CANSLIM) is probably one reason.

CANSLIM is a term O'Neil coined in his 1988 book How To Make Money in Stocks (McGraw Hill, $10.36). Each of the letters in the acronym stands for a basic investing tenet of the strategy. “C” stands for current quarterly earnings per share (which must be up at least 18 percent on any stock an investor plans to buy); “A” is for annual earnings per share (which should show meaningful growth for the last five years); “N” is for new (buy companies with new management or those that have achieved new highs in their stock price); “S” is for shares outstanding (they should be small in number); “L” is for leaders (buy market leaders and avoid laggards); “I” is for institutional sponsorship (buy stocks with which institutional investors have had success); “M” is for the market (learn to interpret the daily general market indexes and movements of market leaders to determine the overall market's direction).

O'Neil puts an enormous amount of faith in this system's ability to deliver results, and his confidence frequently manifests itself in statements like, “What most people think in the stock market isn't worth knowing.”

He developed CANSLIM by studying 500 winning stocks over time. The system hinges less on company behavior than on the supply and demand for its stock and its ability to grow earnings quickly.

“It's not my system,” he says of CANSLIM. “It's the reality of how the market functions.”

O'Neil is the poster boy for CANSLIM, having earned a large fortune by adhering to it. In fact, when he first applied the strategy to his own portfolio, it made him the top-performing broker in his firm and expanded his personal portfolio 2,000 percent in 26 months. The system works mainly by correcting defective methods of investing. “I made a lot of mistakes in the beginning as a broker,” he says, “and asked what I did wrong.”

The approach clearly has appeal to the investing public. How To Make Money in Stocks, which was updated last year, has sold more than a million copies. Meanwhile, IBD, a veritable mouthpiece for O'Neil's personal investing beliefs, maintains a circulation of 242,661. True, that is down substantially from the 300,000 at the market's peak, but one-in-four securities employees still read the paper, according to Mendelsohn Media Research.

Still, there are naysayers aplenty. “He is a good marketer of himself and his theories, but he presents selective evidence,” says Morningstar fund analyst David Kathman of O'Neil.

Kathman says that no mechanical strategy consistently beats the market over long periods of time, and that anticipating where stocks are going based on recent past performance and volume is nearly impossible. “You can't make absolute rules,” he says.

Skeptics like Kathman call CANSLIM a “mishmash of different strategies,” none of them original but some worthwhile.

O'Neil bristles at the notion that he is a momentum investor, but his critics point to his obsession with relative strength and surmise that the label applies.

Others fault O'Neil's strategy for the way it courts volatility. O'Neil himself admits to the importance of watching CANSLIM-guided investments carefully, since you must sell them if they drop by a mere 7 percent or 8 percent.

“You must cut all losses,” he says. “No matter how smart you are, you'll make mistakes, so you must have a defensive method.”

The Believer

Of course, that can be easier said than done. O'Neil devotee Barry Darvin, president of Darvin & Co, a brokerage firm in Troy, Mich., couldn't unload his shares of Worldcom before its legendary blowup, because “It went down quicker than I could get out,” he says. That said, he took a 22 percent loss. It could have been worse.

But Darvin has religion. He reads IBD every day, looking at the money flow charts to see where investors are heading. He also looks at the most active stocks and their ratings. “I don't read the news,” he says. “I look at the technical aspects.” After uncovering stocks using CANSLIM, he double-checks them against Bear Stearns recommendations.

“It's a momentum style of investing,” he says. “But momentum is good if you have earnings and institutional sponsorship.”

But Kathman likens CANSLIM to data mining. It's “a trap people fall into” he says of predicting the future based on past share-price movement. Besides, the problem is that once a winning strategy is discovered, the market exploits its future potential. “Excess returns are neutralized once people become aware of them,” he says.

That's why some brokers cherry pick O'Neil's theory. James Brookes-Avey, an investment advisor at Momentuminvesting.com learned that the hard way. He used CANSLIM to buy Key Energy, which rose dramatically in the late 1990s. He declines to say how much money he lost, but the stock “went straight down” soon after he bought it, he says. And his is not an isolated case. “There are stocks that crash 30 percent to 40 percent in a single trading session,” he says, noting that this is especially true if they have a small float. “The price momentum can evaporate rapidly if things start to go wrong.”

Also, trading costs and taxes tend to chew up returns, points out Mike Gentile, an investment advisor at William Blair & Co. in Chicago. Gentile, who is a “growth at a reasonable price” investor, says that under O'Neil's approach, “one bad trade can wipe out four good ones.” To avoid such pitfalls, he and partner Buzz Chandler cobbled together their own investment formula from “bits and pieces” of O'Neil's strategy. “To succeed in this business, you need to synthesize things from successful models,” he says.

“The secret to making money is not losing it,” says Gentile. “It's not what you've won. It's what you've kept.”

A Vote of Confidence

The naysayers got a kick in the teeth when the American Association of Individual Investors recently released a study vindicating the CANSLIM theory. By using CANSLIM as a screening system for five years, AAII found that it's “one of the most consistent and strongest-performing screens during both bull and bear markets.” It outperformed from 1998 to 2002 with a 350 percent gain. AAII's conclusion: It is a good strategy for “active investors looking for growth stocks.”

Part of the problem for many advisors is that O'Neil is not troubled by high price-to-earnings ratios. High P/E stocks tend to be volatile, which is why O'Neil and advisors compare the P/E to the forecasted earnings growth rate of the stock.

“What seems too high and risky to the majority generally goes higher, and what seems low and cheap generally goes lower,” says O'Neil. That amounts to market timing, say some: buying rising stocks, and selling immediately when they begin to stall or fall. Says Kathman: “Day trading is another name [for this].” He advocates buying an investment for the long term and not expecting big returns.

To succeed with CANSLIM, “you've got to make a lot of very good decisions,” says Barry Morgan, a managing director at Robert W. Baird. He, like others, believes that the fewer investments made, the better. “The reason to invest is not because the stock is going up,” he adds. “It's because you believe the company will make more money 5 to 7 years down the road.”

Nonetheless, a hair-trigger selling discipline appeals to many. “O'Neil has discipline on the downside,” says William Blair broker Dick Gottfred. “That's saved a lot of people in the market.”

O'Neil, for his part, says his approach is sound because it is based on a set strategy, not on knee-jerk reactions. “You must have sound buy and sell rules,” O'Neil says. “You must have discipline. You have to take a loss. Everybody got wildly carried away in 1998 and 1999. But you didn't have to buy companies with no earnings. It's very basic to buy companies that are making money.”

O'Neil, ever the optimist, is publishing a new investing book this year. And recently, O'Neil began heavily investing in the market again. From 2000 to 2003, he was only 10 percent invested.

“Most downturns happen for three years,” he explains, “and we're at that now.”

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