What’s growth investing?

What’s growth investing, how does that compare with value investing, and is one better than the other? This seems a simple question. The simple answer is – that depends.

We already looked at value investing with a thorough review of the widely accepted reference work on that subject, The Intelligent Investor, by Benjamin Graham.

There are many books that explain growth investing, some are excellent, and some less so. Here we will take a close look at growth investing with a detailed review of the book “How to make money in stocks.” by William J. O’Neil. This very popular book is a step by step guide to growth investing.

Many of the most recent books on investing are also shameless promotional vehicles for online investing subscription services. This book suffers a little from that. On the other hand, it does provide a complete guide to growth investing.

CAN SLIM

You may have heard of this before. O’Neil uses a simple two-word acronym to capture the main points of his system. CAN SLIM is not just a mantra for the diet fanatic, this is what the letters stand for:

C – Current quarterly earnings and sales. They should be as high as possible

A – Annual earnings per share. Compare the current quarter with the same quarter last year by at least 30 percent

N – New, something new. New products, new management, new market, new industry.

S – Supply and Demand. Big volume demand at key points.

L – Leader or Laggard. You want your stock to be a leader

I – Institutional accumulation and support.

M – Market direction. You have to invest in the direction of the market.

There is a small chapter dealing with each of these aspects in turn. We will look at those later.

Other pointers

O’Neil listed some other basic do’s and don’t’s

• Buy stocks on their way up, not on their way down
• Buy more when the price has risen from your purchase price, not dropped
• Buy high priced stocks not cheap stocks
• Sell your positions if they drop by 7 or max 8 percent. Otherwise, they will drop lower
• Ignore book value, dividends, and price/earnings ratios
• Focus on:
  • strong earnings growth,
  • sales growth,
  • market price and volume action,
  • leaders in their fields
• Ignore newsletters, analysts
• Watch daily, weekly and monthly price and volume charts
• Use consistent market entry and exit rules.

Study yesterday’s winners to spot tomorrow’s

This is the reasoning behind the main principles of O’Neil’s approach. His point is that the big winners of the past all shared many features in common. By studying those features, and most importantly the behavior and the characteristics they were exhibiting before their price started a big rapid climb, we can find and invest in stocks likely to perform the same stratospheric price soaring feats.

It’s all in the charts

O’Neil is a strong proponent of studying price and volume charts. He considers a number of classic chart formations but notes that some of these are more reliable than others and some are not only rare but very hard to spot.

One of the main points to take on board is that reading price and volume charts is a skill that is developed over time. Different stocks can develop similar chart formations that may look as if they will build into a significant price uptrend and yet some of these will fail.

Another interesting finding is that some price formations that worked well in the boom of the 1920s and to some extent in the dot com bubble of the late 1990s don’t work well and have tended to fail in most of the more measured bull markets of recent times.

The chart formations that make it onto his list are: cup and handle, saucer and handle, coil, pennant, flag, double bottom, triple bottom, inverted head, and shoulders, Of these patterns the one given the most attention is the cup and handle.

Cup and handle

The cup and handle formation is considered and explained at great length. O’Neil considers this so important he devotes 100 pages to reproducing the charts of big winners stretching back to the late 19th century.

His point is that of all the patterns he observed looking at the price and volume charts of the huge winners studying closely the period before their prices broke out and began their astronomical rises, a well-formed cup and handle formation was the most frequently seen.

Since the base of the cup typically takes between 12 and 24 weeks to form, though it can take as little as 7 or as many as 65 weeks, it is often easiest to spot the formation on logarithmic weekly price charts.

In addition to the price and trading volume of the stock, you need to track, the most relevant major market index, the 10-week moving average, the relative strength of the stock vs that index, and the quarterly earnings. All of these should be plotted on logarithmic charts.

Characteristics of a well-formed cup and handle

There are distinguishing features of a proper cup and handle formation

• Base should be a U shape, not a V shape
• Base should form over 12 to 24 weeks but this can be as short as 7 or as long as 65 weeks
• Handles should take between 1 and 5 weeks to form
• The price correction from the tip of the cup should be at least 12 to 15 percent but can be as much as 33 percent to the bottom of the base
• An increase of at least 30 percent from the prior uptrend pattern to the tip of the cup

• Improving relative strength on the prior pattern
• Increasing trading volume during prior uptrend pattern
• Cup base often forms during market corrections but should show good relative strength
• In a market correction, the price should not decline more than two and a half times the market

• Volume should dry up at the low points of the base.
• The handle should form in the upper half of the base and above the 10-week moving average
• Handles should drift down in price
• The price drop of the handle should be around 8 to 12 percent from the peak unless the base of the cup is very large
• Weekly price patterns during handle formation should be tight, i.e. no great difference between price highs and lows.

• A price breakout to the upside occurs when the price makes a strong move on dramatically increased volume and breaks above the high point at the start of the handle.
• The increase in trading volume should be at least 40 or 50 percent of the average daily volume. On big winners, it was often much higher.
• The price breakout is the buy point.

If you wait too long and miss this point entering 5 or 10 percent higher you are more likely to be shaken out when the first correction occurs.

The low volume at the price low points of the base and the last week or two of the handle are important indicators that sellers have been exhausted and institutions are accumulating the stock.

You have to look carefully at volume though since institutions often buy over time. Watch volume and price in a base that is forming. If the number of weeks when the stock is up on above-average volume is greater than the number of weeks when the stock closes down on above-average volume, that is an indication that institutions are accumulating the stock.

Other price formations

O’Neil briefly considers a number of other price formations, including:

• Saucer and handle – is like the cup and handle but not as deep and is longer. Because of the lesser correction in the base of the saucer, it tends not to be as strong an indicator of a big winner as the cup and handle
• Double bottom – occurs quite frequently. The second bottom has to form a lower low than the first. When the price breaks up from the second low above the level of the middle peak, that is the buy point.
• Flat base – often forms after a regular cup and handle.
• Flags – high and tight flags are rare. Price moves up sharply over one or two weeks, then moves sideways over three to five weeks dropping between 10 to 25 percent but in a tight formation. This is a rare but powerful formation and difficult to spot.
• Inverted head and shoulders, and triple bottom – are popular patterns and easy to spot but usually not a precursor to a big price upward move.

The looser and wider these formations are the weaker they are and the more likely they are to fail if and when the price breaks out in an upward direction.

C is for Current

In O’Neil’s view, massive increases in quarterly Earnings per Share right before the price breakout is the single most important factor indicating the start of a huge price uptrend. Current quarterly earnings should be compared with earnings for the same quarter last year to eliminate seasonal effects. The increase should be at least 25 to 30 percent, much higher is much better.

Make sure you subtract any non-recurrent earnings. The only earnings counted should be from regular operations. Sales growth should match earnings growth. Also, look that the company is still spending regular amounts on research and development and marketing and isn’t artificially boosting earnings. Earnings increase should be from increases in regular operational sales.

The price breakout also needs to happen at the beginning of a general bull market. Check how other companies in the same industry sector are doing. Ideally, you want a few other leaders to be surging forward in market price and Earnings per Share too. It will be a bigger and more reliable uptrend for your stock if it isn’t alone.

What you really want to see is not just increased Earnings per Share, but accelerating growth in Earnings per Share at the time of the price breakout.

A is for Annual

Here you are looking at annual growth rates in Earnings per Share and other indicators of financial health.

Check the annual increase in Earnings per Share over the last three or more years. The annual increase should be at least 25 percent. The growth should also be accelerating and stable with no dips. The easiest way to see this is that accelerating growth shows a straight upward line on a logarithmic chart.

The company also should have financial strength. Return on Equity should be at least 17 percent. The company should also have a strong cash flow, and Earnings before Interest, Tax, Depreciation, and Amortization, or EBITDA should be at least 20 percent more than Earnings per Share. The Debt to Equity ratio should also be at or below the average for the industry.

O’Neil also warns against the trap of buying low Price Earnings ratio stocks. He argues that stocks usually have low Price-Earnings ratios for a reason. These are often cyclical stocks that may be experiencing temporary good results. While gains can be made trading such situations they will almost never turn into astronomical winners.

N is for New

A new company, or a new product, or a new industry or new management is a feature common to all big winners. The point is that there will be some sort of innovation behind huge growth. The other side of new management is to avoid companies with entrenched caretaker management. They will usually struggle to make above-average earnings anyway so they are unlikely to have made it this far in your selection process.

Here O’Neil explains the great paradox of stocks – stocks that have achieved new highs usually go on to achieve further highs, and stocks that have achieved new lows usually go on to achieve lower lows.

S is for Supply

Look for companies whose managers own between one and three percent of the publicly traded stock. This is likely to mean smaller cap stocks rather than large and mega-cap stocks. Stock buybacks are also a good sign.

Something to avoid is excessive stock splits. While stock splits can make the stock available for more buyers, it is also likely to result in more sellers.

Look for trading volume that confirms the price uptrend. When the price pulls back during a correction, you want to see volume dry up. When the price makes new highs you want to see this on higher than average daily volume – typically 40 to 50 percent more is what you will want to see.

L is for Leader

Or Laggard. You want the stocks you buy to be leaders, not laggards. This usually means you want your stock to be among the top two or three in any one industry.

Don’t buy sympathy stocks. It can be tempting to buy the second or third company in a burgeoning industry because you worry that the leader’s stock price is already too high, and you think that the follower will be lifted by the rising tide. While other companies in the industry may be pulled up somewhat, their returns will usually pale in comparison to the leader.

To make the point about leaders, O’Neil reproduces a famous quote of the steel magnate, Andrew Carnegie who said about new innovative industries:

“The first man gets the oyster, the second man gets the shell.”

I suppose observing how many new companies fail at new innovative enterprises, you could cynically say,

“You mean the first man to make it back from the oyster bed who doesn’t get eaten by sharks!”

What separates and how do you recognize leaders within a group – the answer is relative strength. Relative strength is just the price performance of one stock compared with another or with an index over the same time period. There are a number of online charting services that will allow you to plot the relative strength of a stock in this way.

The relative strength of a stock compared with its industry group or the market is not to be confused with the commonly used Relative Strength Indicator, or the RSI. The RSI is a measure of price action compared with its recent past.

The leading stocks in a group will have a high relative strength compared with the group. Relative strength is just a numerical way of expressing superior stock price performance of one stock against others.

I is for Institutions

It is estimated that in today’s markets approximately 90 percent of stock ownership is in the hands of institutions. Institutions include investment banks, pension funds, mutual funds, hedge funds, insurance companies, and many others. Unlike retail investors, institutions have to make public declarations about their investment strategies and their holdings. In today’s market, there are approximately 10,000 institutions.

In simple terms, you want to see that your stock has institutional sponsorship, i.e ownership.

Many online brokerages track and publish the number of institutions owning a stock. As the institutions are obliged to publish this information quarterly, you can track the number of institutions owning a stock.

You want to see that the number of institutions owning a stock is increasing quarter on quarter. That is a good sign, but as noted earlier you have to watch volume in up weeks and volume in down weeks. The sign of institutional accumulation is that the average daily trading volume in up weeks is higher than in down weeks.

The other useful technique is to read the prospectus of the leading mutual funds and look at the stocks they are buying.

M is for Market

The key point here is that if you get all the other factors right –

• you find leading stocks whose quarterly earnings and sales are accelerating,
• annual earnings and sales are up,
• with a new innovative product, service or management,
• with healthy price and volume action,
• showing institutional accumulation,
• breaking out from a well-formed base…

– if the general direction of the market is down, then your stock will likely be dragged down with it. When it comes down to it you need to know whether the current market is a bull market or a bear market. You need to know what phase the market is in.

That is really just the start. As explained here the market goes through cycles. If it is a bull market, you need to know whether it is the start of a new bull market or if it’s coming to the end of a bull market.

If the market is going down you need to know whether that is a full-blown bear market that will take prices down 30 to 50 percent or more from their peak. Or whether it is a short term correction that will drop prices by 10 or 15 percent temporarily before prices carry on in a previous upward trend.

O’Neil’s point is that you need to learn how to read the general market.

A general observation here and this is an important distinction between value investing and growth investing. If your portfolio has a high proportion of growth stocks, and it will if you are following a growth strategy, you will need to get out of the growth stocks before big bear markets.

What the value investors say:

One of the standard criticisms, value investors level at the proponents of growth investing, is that growth stocks may do well in bull markets but they get hammered in bear markets and since nobody can reliably time the market to get out at the top, investing in growth stocks will doom you to underperform the market.

As you can see this hypothesis rests on the conviction that you cannot time the market.

What growth investors say:

O’Neil’s firm position is that you can and absolutely should time the market. In particular, you should study the market. You should study how markets have shifted from the bottom accumulation stage, through long bull markets to the market top and distribution stage leading to a bear market.

Most important, is to recognize the market top.

Market tops can be seen in the price and volume action of major market indexes. What we need to look for are the unmistakable signs of institutional distribution. Bull markets typically last two or three years or more and usually take three or four pullbacks before being well and truly tipped into a full-blown bear market.

How to spot the market top

What the daily price and volume of the major market indexes, the Dow Jones Industrial Average, the Standard and Poor’s 500, the New York Stock Exchange Composite, and the NASDAQ Composite.

• look for an up-day following a previous large up-day when the volume on the second day is higher than on the first but the price gain is significantly less or can even decline.
• what you are looking for is a stalling price on increasing volume.
• the difference between price highs and lows of the day can widen, but the close is either down or up slightly.
• a distribution day is a price decline of 0.2 percent or more on a higher than average volume
• institutional distribution occurs typically on specific days over a four to five-week period while the price is still moving higher
• this pattern only needs to be seen on one of the indexes for the reversal to happen
• then the market will start to move lower
• typically the market will then try to rally
• usually, the rally will last up to five days
• each day the price increases on a lower volume than the previous day
• each day the price advances less than half the drop of the previous day
• five or six distribution days is enough to tip the overall market trend downwards.

Those are the signs. To push this point home O’Neil shows the price charts and highlights the distribution days of a number of familiar market tops in the last 30 years and includes the 1929 crash for good measure.

Watch the leading stocks

At market tops when institutional distribution is happening leading stocks may start behaving erratically. Leading stocks will form weak and loose bases and then have failed rallies. Some of these rallies may succeed but the bear market will eventually pull them down. This even happens when those leading companies have reported accelerated earnings.

A market top reversal typically happens on a day when the market makes a new high but closes near the low of its trading range.

Watch out if the laggard stocks start to lead. If the market is trying to rally after a bear market starts and the attempted rally is lead by stocks that have lagged throughout the preceding bull market, the attempted rally will fail.

Spotting the bear market bottom

Bear market bottoms at the basing stage turn around much faster than bull markets turn into bear markets. During the bear market prices will have rallied three, four, or five times. The question becomes whether a rally will stall and fail or whether it will mark the bottom of the bear market and reverse to a bull market.

By the time the market starts to bottom, institutional accumulation will already have started. The first day the major market index closes higher than the previous day is the first day of the attempted rally.

It would typically be on the fourth to the seventh day of the attempted rally or later when one of the major market indexes follows through with a large gain on heavy volume. The rally on this day needs to be strong, a gain of at least 2 percent and preferably 3 percent, and closing near the high is what you are looking for.

Other indicators of market turning points

O’Neil points out that rallies of the major indexes can be fake and can stall. There are other indicators to watch:

• divergence of key moving averages, for example, the 40-day and the 20-day.
• market sentiment – the percentage of investment advisers who are bullish vs bearish
• the market advance/decline line – the percentage of stocks that are advancing in price vs declining in price.
• overbought and oversold indicators, like the RSI
• upside/downside volume – is the trading volume of stocks that closed up vs the trading volume of stocks that closed down. Plotted on a 10-day moving average, this indicator can diverge from price on intermediate turning points.

Cut your losses

This is one of O’Neil’s strongest lessons. He advises you to have the courage and discipline to sell any and every losing position if it drops 7 to 8 percent below what you paid for it.

He even advocates doing this in increments. For example adopting a rule that if the price of a stock drops 5 percent below the price you paid, sell 50 percent of your holding. If it drops to 7 percent, then sell the other half.

Another important dictum is – never average down in price. That would actually be the reverse of selling a losing position.

Take your profits

A stock will climax at the top of a run-up and show various signs.

Exhaustion gap – if the stock gaps open after a long run-up lasting many weeks. This is called an exhaustion gap and is often a sign it has reached its peak

Institutional distribution – is often seen when a stock is topping out on heavy volume with little increase in stock price.

Down-days start to outnumber up-days – if the previous weekly pattern was 3 or 4 up-days and 1 or 2 down-days in a week, but that now reverses and becomes 1 or 2 up-days and 3 or 4 down-days.

Stock breaks out of its upper channel – after a run-up lasting many weeks if the stock breaks above a line connecting the main price highs since the last breakout from a price base, it is likely reaching its climax.

Above the 200-day moving average – if the stock is 70 or 100 percent above its 200-day moving average.

These are signs the stock is hitting its top and it is time to sell and take your profits.

How many stocks to own

Another principle followed by many growth investors following these kinds of precise and careful systems is to limit their portfolios to a few stocks. The rationale is that you can’t give the attention needed to more than about 10 stocks maximum.

So what to do if you already have 10 stocks and find another that has all the strong signs? – then sell one that you already own that is giving you the worst or the least good signs.

In a nutshell – that’s it. By “that” I mean all that you’ve read so far. Assuming that you have managed to read this far.

What I think

One criticism you will see frequently about this book is that a lot of pages are taken up with promotions for the Investor’s Business Daily which is O’Neil’s subscription service. That is certainly true and hard to escape especially at the end of the book. On the other hand, if you really do want to follow his system you probably need to take the service to access all the research you need to find stock opportunities and make good buy and sell decisions.

Another impression that is hard to escape is that it often feels he is trying to sell the American way of life in contrast to communist or socialist variants. This is strange as the Berlin Wall came down 20 years before the publication date. But that may just be a personal quirk.

Another little beef is that the astronomical gains mentioned on the huge run-ups particular stocks have experienced are always shown from the breakout from a base to the top of a price climax. You have to read much further in the book for the admission that few investors or traders will, for example, buy and hold Microsoft from its breakout until its peak, unless you happen to be Bill Gates.

Another point I should clarify is that O’Neil’s method is an approach to growth investing. There are other approaches to growth investing, including just to pick a few growth funds and make regular monthly contributions. Here is an article that explains different approaches to growth investing.

If after reading this you do want to learn and apply the CAN SLIM method, then you will need your own copy of “How to Make Money in Stocks” by William O’Neil because as he says, you probably will need to read it a few times

This article contains affiliate links.

You can buy a copy at BOOKS-A-MILLION here.

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Answers to questions

Q. Are growth funds good investments?

A. On average, high-quality growth funds perform well over most 10 and 15 year periods.

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Q. What is better, growth investing or value investing?

A. This is really a personal choice. I would advise studying what they each mean, decide what works for you, and stick with it.

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Q. How do I invest money for growth?

A. One approach is to buy one or more managed growth funds. Other approaches involve active management of your own stock portfolio. Active management of your stock portfolio requires study and discipline to select and consistently follow stock selection and buying criteria and clear and consistent selling criteria and sound risk management.

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Here is a single-page summary on growth investing as explained in How to Make Money in Stocks available as a PDF download.

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