How to Make Money in Stocks - critical summary review

There are many different methods of trading in the stock market. There are, for example, active trading strategies, such as day trading – the method of buying and selling securities within the same day – or swing trading – a style of trading that attempts to capture short-term gains in a stock. There are also many other far more passive trading strategies, such as value investing, which involves picking stocks that appear to be trading for less than their intrinsic or book value and keeping them for a long period of time. 

“How to Make Money in Stocks” by William O’Neil is about none of these approaches. It is, instead, the best book out there on growth investing – the process of investing in companies or industries that are currently growing and are expected to continue their expansion. Get ready to learn how to identify them and how to make money out of their growth!

The essence of growth investing

It seems intuitive to buy stocks when their price is on the way down. After all, provided we’re talking about a good company here, the price of its stocks is bound to go up one day, isn’t it? The cheaper you buy its stocks, the more you’ll earn when the market inevitably reappraises them in accordance with their intrinsic value, that is to say, their true, actual worth. This is the logic that brought immense wealth to investors such as Warren Buffett and Charlie Munger. It is not, however, the trading strategy O’Neil advocates, nor is it the one responsible for his riches and affluence.

According to O’Neil: “You should buy stocks when they’re on the way up in price, not on the way down. And when you buy more, you do it only after the stock has risen from your purchase price, not after it has fallen below it.” Moreover, you should buy stocks “when they’re nearer to their highs for the year, not when they’ve sunk so low that they look cheap. You buy higher-priced stocks rather than the lowest-priced stocks.” The basis of growth investing, these are only two of O’Neil’s numerous stock picking secrets. Just like all the others, at first glance, they seem counterintuitive and completely contrary to human nature. So, be it: O’Neil claims that charts prove him right.

Reading charts: the cup and handle pattern

According to O’Neil, the market follows its own laws and has its own behavior, rooted not only in evolution and human nature, but also in crowd psychology and the age-old law of supply and demand. “Because these factors have remained the same over time,” he explains, “it is remarkable but true that chart patterns are just the same today as they were 50 years ago or 100 years ago.” 

To prove this, O’Neil analyzes no less than 100 charts of the greatest stock winners from 1880 through 2008 and eventually arrives at no fewer than three fascinating conclusions:

• In the stock market, history repeats itself. Whether it is because of unchanging human nature or because of the iron law of supply and demand, there are some “successful price patterns and consolidation structures” that repeat themselves over and over again throughout stock market history. Consequently, “price patterns of the great stocks of the past can clearly serve as models for your future selections.”
• Investing is all about recognizing cups and handles. The most common winning chart pattern in history looks like “a cup with a handle when the outline of the cup is viewed from the side.” Think of it as the letter “U” with a lever on its right side. The pattern suggests that a winning stock, after rising in price for some period of time, will eventually fall. However, it will not collapse, but stabilize – hence, the base of the cup. Then, after some period of time – anything between seven weeks to a year – it will start climbing upward again (forming the other side of the cup), before dipping slightly back to form the handle. This is the moment when you should buy the stock. The “handle” hints at a new move to the upside and is considered a fairly reliable bullish signal.
• The winning stocks of the past have seven common characteristics. These characteristics can be summarized in a two-word, easy-to-remember formula: CAN SLIM. Each letter in the acronym stands for one characteristic. Allow us to go over them all.

C = Current big or accelerating quarterly earnings and sales per share: the higher, the better

Buying stocks when they’re on the way up in price is the essence of growth investing. According to O’Neil, the key question for any winning investor should be: “How much are the current quarter’s earnings per share up (in percentage terms) from the same quarter the year before?”

Put simply, always compare a company’s December quarter’s earnings per share (or EPS) to the December quarter of the previous year – not to the prior September quarter. “The stocks you select,” advises O’Neil, “should show a major percentage increase in current quarterly earnings per share (the most recently reported quarter) when compared to the prior year’s same quarter.”

That said, don’t sell yourself too short: O’Neil considers 10% or 12% EPS increases to be mediocre, noting that the best companies usually show earnings up 100% or even 500%! So, at a minimum – and for starters – target 25% to 50% current quarterly EPS increases over the same quarter the previous year. “When you’re picking winning stocks,” concludes O’Neil, “it’s the bottom line that counts.”

A = Annual earnings increases: look for significant growth

Strong quarterly earnings per share may be critical to picking a winner, but they are not enough. After all, any company can report a good earnings quarter every once in a while. So, to be sure that you’re picking the right company, you need to delve a bit deeper and review the company’s annual growth rate. 

You can easily check both. In the research stock tables of the Investor’s Business Daily (a magazine founded by none other than O’Neil), every stock is listed next to a proprietary EPS Rating. IBD’s unique EPS Rating takes into account the growth rate of a company over the previous three years, by comparing its two most recent quarters of earnings growth against the same quarters in the past. 

Next, it compares the result to those of the other publicly traded companies and rates it on a scale from 1 to 99. An EPS rating of 80 means a company has outperformed 80% of all other companies (in terms of both annual and recent quarterly earnings performance) over the previous three years. So, the higher the EPS rating, the better. Always look for companies with significant earnings growth in each of the last three years and strong recent quarterly improvements.

N = New products, new management, new highs: buying at the right time

In 1963, Mexican pharmaceutical giant Syntex started marketing the oral contraceptive pill. In six months, its stock soared from $100 to $550. The stocks of Cisco Systems soared an unbelievable 75,000% in the 10 years after the California-based tech corporation started selling routers and networking equipment. Apple’s stocks have risen significantly several times during the past two decades, each time following either a change in management (the return of Steve Jobs) or the introduction of a new product (iPhone, iPad, iPod).

The lesson: for a company to be a winner it must have continuing development and innovation. It doesn’t matter how big a company is: what matters is how much bigger it can get after developing a new product or service, or after changing the management. As much as it may seem hard to believe, the following great paradox has always been true for the stock market: “What seems too high in price and risky to the majority usually goes higher eventually, and what seems low and cheap usually goes lower.” 

So, don’t bother with missing past golden opportunities. The better the company, the more such opportunities you can get from it in the future. For example, Apple’s stocks have surged several times since “trading experts” first predicted they must have plateaued. Almost every time, the surge followed a new product and a “cup with a handle” price pattern.

S = Supply and demand: shares outstanding plus big volume demand

In a market-based society, the law of supply and demand determines the price of everything. The more there is of something (supply), the less valuable it is (and vice versa). Just as well, the more something is wanted (demand), the more valuable it becomes (and the other way around).

Consequently, it would require a huge volume of buying (or demand) for the price of a company’s stock to budge if said company had issued, say, 5 billion shares outstanding. On the other hand, a stock with 50 million shares outstanding (a relatively small supply) can shoot up quite quickly, because only a reasonable amount of buying is required to push up the price. Hence, all other factors being equal, a smaller stock has the potential to be the better performer than a bigger one. However, a big company will always be a more reliable investment. 

Speaking of reliability, it matters who owns the shares as well. As a rule of thumb, stay away from companies wherein top management owns only a small percentage of the shares. In contrast, always be on the lookout for companies buying back their own shares. The act suggests their managers believe the company’s stock will soon be in high demand again.

L = Leader or laggard: which is your stock?

Whenever possible, O’Neil suggests, buy the leading stock in the leading industry. By “leading,” he doesn’t mean “the largest company or the one with the most recognized brand name” but “the one with the best quarterly and annual earnings growth, the highest return on equity, the widest profit margins, the strongest sales growth, and the most dynamic stock-price action.”

The best way to separate leaders from laggards is Investor’s Business Daily’s proprietary Relative Price Strength (RS) rating, which measures the price performance of a given stock against the rest of the market for the past 52 weeks on a scale of 1 to 99. The higher the number, the better. O’Neil’s analyses demonstrate that throughout modern history, “the average RS Rating of the best-performing stocks before their major run-ups was 87. In other words, the best stocks were already doing better than nearly 9 out of 10 others when they were starting out on their most explosive advance yet.”

So, don’t just avoid stocks with RS ratings under 50, but also skip those in their 60s or 70s. Look only for market leaders which show RS ratings of 80 or higher. The big moneymakers usually have RS ratings of 90 just before they break out. You want them, not some sympathy laggards. 

I = Institutional sponsorship: follow the leaders

The biggest source of demand for stocks is institutional investors. They can be anyone from mutual funds and hedge fund managers through insurance companies and bank trust departments to charitable and educational organizations. Institutional sponsorship refers to “the shares of any stock owned by such institutions.”

A winning stock, according to O’Neil, “doesn’t need a huge number of institutional owners, but it should have several at a minimum.” Since it takes big demand to push up prices, even when institutional sponsors are wrong, given that they are the biggest buyers, they are still good for you. In other words, if you own shares that big institutions are buying, then their price will rise, regardless of their inherent value.

Of course, there is a limit to the number of institutional sponsors that is beneficial to your trading practices. Because the more popular a share is among institutions, the less its price can move upward. Every institution owned a Xerox share in the 1970s and a Gillette stock in the 1990s. That was the problem: no more could be added. Hence, to quote O’Neil, “buy only those stocks that have at least a few institutional sponsors with better-than-average recent performance records and that have added institutional owners in recent quarters.”

M = Market direction: how to determine it

Even if you are right about every one of the first six factors, you can still lose money if you are wrong about the general direction of the market. That’s precisely what happened in 2000 and again in 2008. If the direction of the general market is down, then three out of four stocks will plummet along with the market averages, regardless of their performance records and prior annual increases.

But how do you judge the mood of Mr. Market, that famous manic depressive, according to Benjamin Graham? It’s easy, says O’Neil: just study closely general market indexes such as the S&P and NASDAQ every single day. The unwritten rule is this: stocks open strong and close weak in bear markets, but open weak and close strong in bull markets. Ignore such signals at your peril. As we already mentioned, 75% of all stocks tend to follow the general market direction.

Final notes

Currently in its fourth edition, “How to Make Money in Stocks” has influenced generations of investors. In addition to becoming parts of the common stock market jargon, both the cup and handle pattern and the CAN SLIM trading formula have helped millions of traders minimize their risks and maximize their gains. A classic in its genre.

12min tip

Buy stocks when they are up in price and near to their highs for the year. Focus on profit growth, price and volume action. Choose leaders over laggards. Learn to read charts and to look for the cup with a handle pattern.