"Buy low, sell high": for decades, it's been one of the most-used mantras in the investing world. Find good stocks that are undervalued and selling at low prices, purchase them, and sell them after their values rise. It seems like perfect (albeit simplistic) logic for those looking to make money in the stock market, right?
Not to William O'Neil. After an extensive study of nearly four decades worth of the stock market's biggest winners -- which he detailed in his best-selling book How to Make Money in Stocks -- O'Neil found inherent flaws in the "buy low, sell high" adage. According to him, stocks selling at low or reduced prices are doing so for a reason: they aren't great companies, and their stock prices aren't likely to increase all that much. If you want to get the best stocks, he says, you have to pay a premium. In other words, buy low, and you likely won't get the chance to sell high; buy good stocks high, however, and you should get the chance to sell them higher -- sometimes much higher.
One of the aspects of O'Neil's strategy that I like is that he is a big believer in learning from history. When I was trying to find ways to beat the market, I studied the approaches of several of history's best investors, which led to the development of my "Guru Strategies" -- computer models that are each based on the approach of a different investing great. O'Neil also relied on history's best, but in his case he focused on the best individual stocks. In his landmark study, he identified more than 500 of the biggest winning stocks during the period from 1953 to 1990, and then searched for qualities that they shared leading up to their big price run-ups. By looking for new companies that had those same characteristics, he believed he could identify more stocks that were primed to make huge gains.
O'Neil's findings were big news on Wall Street, and they became the basis for one of my Guru Strategies. But the study is far from O'Neil's only contribution to the investment world. In 1984, he founded Investor's Business Daily, a research-intensive financial newspaper that serves more than 800,000 investors across the globe. In addition, his 44-year-old investment research firm serves more than 400 major institutional money managers around the world.
Before we look at my O'Neil-based model, one note: part of O'Neil's approach involves market timing. I don't believe in trying to time the market, because I think it leads to more trouble than it's worth. In O'Neil's case, his market timing tips are also complex and subject to some interpretation. My O'Neil-based model thus sticks mostly to the fundamental-based portions of O'Neil's approach. Since its July 2003 inception, this model has almost doubled the S&P 500's gains, and this year it has really excelled, gaining 38.6 percent -- more than eleven times the S&P. Here's a look at how it works, and at some stocks that it thinks are ready to catch fire.
Earnings, earnings, and more earnings
While O'Neil found a lot of similarities in those 500 elite stocks he studied, one factor stood out as the most important: "The profits of nearly every outstanding stock were booming." To O'Neil, if a company's earnings aren't growing significantly, its stock price isn't likely to grow either. "There is absolutely no reason for a stock to go anywhere if the current earnings are poor," he wrote. "Even if the present quarter's earnings are up 5 to 10 percent, that is simply not enough of an improvement to fuel any significant upward price movement in a stock."
Because a company's total earnings can be diluted if more shares are added, O'Neil always looked at earnings per share, not overall earnings. And he looked at EPS in a number of ways, including:
As an example of a stock that meets these O'Neil-based earnings requirements, let's look at Transocean (NYSE:RIG), a U.S.-based provider of offshore drilling services for oil and gas wells. Transocean's EPS are up more than 236 percent this quarter, while its annual earnings growth rate over the past five years has been 37.72 percent. In addition, Transocean's EPS have increased each year over the past five years, and its EPS growth in the last two quarters -- 144.9 percent and 236.2 percent -- are both more than 125 percent of that 37.72 percent long-term growth rate. This firm is growing at an excellent rate according to my O'Neil-based model.
Price: Up, up, and away
Many of the gurus I've discussed before have been bargain hunters. They looked for stocks whose prices were low relative to their earnings, sales, cash flows, or a number of other measures. For O'Neil, however, a stock's price should be on the rise, often because of something "new". Stocks whose prices were being driven higher by new revenue-producing products, new management, new highs or new, more favorable industry conditions caught his eye.
"The staggering majority of individual investors … feel safer buying stocks that look cheap because they're either down a lot in price or selling near their lows," he wrote. "[But] the hard-to-accept great paradox in the stock market is that what seems too high and risky to the majority usually goes higher and what seems low and cheap usually goes lower."
O'Neil was also a big believer in using charts to follow stocks' price patterns. He found that many big gainers showed similar price patterns before their breakouts, and he looked for these patterns when buying stocks. O'Neil's charting patterns are complex and can be difficult to completely computerize, but I've included a few of his price-related measures in my model, including:
- Current price level: O'Neil looked for stocks trading near the top of their range and poised to break out to new highs. The stock should thus be within 15 percent of its 52-week high.
- Relative strength: According to O'Neil, the 500 best-performing listed equities for each year from 1953 through 1990 averaged a relative price strength rating (which measure how a stock has performed in relation to the rest of the market for the past year) of 87 just before their major price jumps. The model I base on his writings requires a stock's relative strength to be no less than 80, and prefers it to be above 90.
- Relative strength line: This measures a stock's weekly price performance compared with the S&P 500 index. The stock's relative strength should be trending upward compared to the S&P over the past four months.
Again, let's look at Transocean. Currently, the stock is selling at $131.81, which is within 15 percent of its 52-week high ($139.99). In addition, its relative strength line has been increasing compared with the S&P over the past four months, and its current relative strength is 88. This is a stock that's been on the rise. To O'Neil that was an indication that more good things were to come.
Fundamentally sound
While momentum -- both in terms of earnings and stock price -- were big parts of O'Neil's approach, he didn't ignore other fundamental variables. For example, he liked companies whose return on equity (a measure of how well management is using shareholders' money) to be at least 17 percent over the past 12 months. And he liked companies that have either consistently cut their debt over the past three years, or that have extremely low debt (less than 2 percent of equity).
Transocean again makes the grade. Its return on equity over the trailing 12 months is 36 percent, and its debt/equity ratio is miniscule at just 0.19 percent. Not only is the firm's stock jumping; its financial house also appears to be in good order.
Safety in numbers
O'Neil also wanted to make sure that he was investing in the hottest industries at a given time. To confirm that a stock was in a strong industry, the model I base on his writings requires that there be at least one other company in the industry with a relative strength score above 80. In addition, it ranks all industries based on the number of stocks within them that have weighted relative strength scores above 80; a company must be in the top 30 percent of those industries, or be among the industries with the most stocks making new 52-week highs.
When it comes to Transocean, the firm is far from alone among its peers. Currently, 27 companies in the oil well services & equipment industry have relative strength scores above 80, one reason it scores high on these tests.
Who owns it?
To O'Neil, it was also important to know who else owned a stock. He liked companies that had strong insider ownership (at least 15 percent) because that means management's interests are in line with those of shareholders. In addition, he thought it was good if some institutions owned the company's stock; institutions have big budgets and have done a lot of research, so if they are ignoring a stock, there must be good reason.
Transocean stacks up very well against these guidelines. More than 31 percent of its stock is owned by insiders, while almost 75 percent is owned by institutions.
Fewer shares, greater rewards
One final part of O'Neil's approach: He found that companies whose stocks made the biggest price jumps tended to have a relatively small amount of shares, because the benefits of good performance are spread over fewer shares. My O'Neil-based model likes firms to have fewer than 30 million outstanding shares, though it doesn't penalize companies with higher amounts as long as they meet all other criteria. Transocean, which has 210 million shares outstanding, falls into that latter category.
While the market has been lagging lately, there are about 18 stocks that currently pass my O'Neil-based momentum method. In addition to Transocean, here's a look at a few others:
Turkcell Iletisim Hizmetleri (NYSE:TKC): The Turkish mobile communications provider has gained about 100 percent this year, and has shown strong earnings growth. Its EPS are up 28.57 percent this quarter and more than 84 percent over the long term. Other reasons my O'Neil-based model is high on it: the firm's 94 relative strength score, and its debt/equity ratio of 0.03 percent.
The Charles Schwab Corp. (NASD:SCHW): This U.S.-based securities brokerage, banking, and financial services giant bounced back well after this summer's financial sector troubles, and has actually gained about 25 percent on the year. Schwab's earnings are up 50 percent this quarter and it has grown earnings each year for the past five years. And while financials have been hit hard, the investment services industry has 31 companies with relative strength scores above 80, including Schwab (81).
Wimm-Bill-Dann Foods (NYSE:WBD): This Moscow-based manufacturer of dairy and juice products is up about 80 percent this year, on the strength of some major recent growth. Its EPS is up 104.55 percent this quarter, its relative strength is 94, and its debt is just 0.22 percent of equity.
One final note about O'Neil's take on investing: He believed that owning stocks wasn't just for the wealthy. O'Neil himself began investing with just five shares of Procter & Gamble when he was 21 years old, and he wrote that beginners can start with as little as $500 or $1,000. So remember, if you're looking to enter the market and don't have a guru-like bank statement, don't be deterred. You may not become a millionaire overnight, but if you stick to a proven, well-rounded strategy you can start now on a path to long-term market success.
Published by Globes [online], Israel business news - www.globes.co.il - on December 27, 2007