The CANSLIM Investing Strategy – A Practical Guide

CANSLIM is an investment strategy developed by investing expert William O’Neil. Each letter in the acronym “CANSLIM” represents an important element of stocks selection, which could be measured by quantifiable variables in an investment decision. The content below is intended as a cheat sheet of the CANSLIM strategy, which includes all the essential formulae that you can put into use immediately.

The acronym CANSLIM actually represents:

• C: Current (Quarterly) Earnings.
• A: Annual compounded earnings.
• N: New conditions in company or industry, and new high in price.
• S: Supply of outstanding stocks.
• L: Leaders in the industry.
• I: Institutional support.
• M: Market direction.

The details are given below.

C: Current Earnings.

O’Neil believes that the first and foremost thing you should look at in a company is its profit-making ability, and he stresses the importance of a strong upsurge in the most recent earnings. Here are the exact tests that he runs through.

Test for Quarterly Earnings per Share (EPS):

Recent increase in quarterly earnings ensures that the company is on the way of rapid development. Here is the criterion:

• Criterion 1a: EPS of the most recent quarter must be at least 18% larger than that of the quarter before. Better yet, it should be greater than 20%. 

If it shows a overall gradual increase for the past year, it is even better.

Test for Seasonality:

Criterion 1a has the drawback that the recent increase in quarterly earnings could be contributed by seasonal reason. Because of this, an additional test has to be constructed to compare with the earnings of the same quarter of the previous year:

• Criterion 1b: EPS of the most recent quarter must be at least 50% larger than that of the same quarter one year ago. Better yet, it should be 100% larger. Apply the same test to the next previous quarter as well.

Note that this test is not always necessary if the company is not in a seasonal business.

Test for Sales:

Sometimes an increase in earnings is simply due to some recent cost-cutting by the company, which does not reflect true growth. To ensure an increase in profitability, here is an additional test for the quarterly sales of the company:

• Criterion 1c: The most recent quarterly sales should at least increase by 25%, or shows a steady increase over the last 3 quarters.

In addition, it would be best if another company in the same industry also sees a similar growth in sales, because it means that the growth is supported by favorable industry conditions.

A: Annual Earnings.

Similarly, O’Neil stresses the importance of steady earning trend of the company for the past 3-5 years, in additional to a strong momentum of growth as outlined above. Below are the several things that he look at.

Test for Annual Compounded Earnings:

O’Neil has a similar criterion for annual compounded earnings as in quarterly earnings. Here is the test:

• Criterion 2: Compounded EPS of the most recent year must be at least 18% larger than that of the year before. Better yet, it should be greater than 20%.

Beware of any one-time non-recurring profit that may distort the actual figure, and they are better subtracted before doing the calculation.

Test for Earnings Consistency:

O’Neil believes that the annual earnings of a consistent company can only tolerate only one year of decrease in its annual EPS in the last 5 years. And, to ensure the strength of growth, unless that “dip year” is followed by a new high in earnings next year, the investment should not be considered. 

• Criterion 3: Only one “dip” of annual earnings is allowed in the past 5 years, and the dip should be followed by a new high in earnings in order to be considered. 

Here is a question: what if the dip happened in the most recent year? In that case, annualize the most recent quarterly earnings and if it is larger than the “dip year” earnings, the test is passed.

Test for Return on Equity:

Here is O’Neil criterion on the return of equity (ROE) of a company:

• Criterion 4: The ROE of the company should be at least 17%, and it is best larger than 20%.

Again, you should subtract any non-recurring gain before computing the ROE.

Test for Long-Term Debt Ratio:

This is an additional test. O’Neil thinks that a good company should have a low ratio of long-term debt, and therefore:

• Criterion 5: Long term D/E ratio should be less than 2%, or gradually decreasing in the last 3 years.

However, please note that this test is not applicable for companies in the banking and finance industry, where they usually have a larger debt ratio.

N: New Conditions for Company or Industry, and New Highs.

“N” represents two things. The first thing is a new condition for the company or the industry behind the company. It could be a new management, a new best-selling product, or a change in the industry. This criterion is purely qualitative, so it can only be researched through the study of news.

Another thing that “N” represents is a new high in price. One of the hardest things to accept in his strategy is that O’Neil does not believe in buying cheap. He believes in buying right. And the best time to buy is often when the price breaks out from a consolidation pattern (e.g. cup-and-handles, double bottoms) with volume to reach a new high. 

Test for Buying Level:

So here is a paradox that O’Neil believes in: if you are buying expensive, you have a higher chance of buying right. Therefore:

• Criterion 6: The buying price must be at least 85% of the previous high, or better yet, when it actually reaches a new high.

As he always said, stocks that go higher tend to go higher, and those do not, tend to do the other way.

S: Supply of Outstanding Stocks.

O’Neil believes that it is better to have less outstanding stocks in the market, because it is more sensitive to the supply and demand, i.e. it goes up faster. Of course, he is aware of the fact that companies of too little shares could be very volatile, so he advises that one has to be particularly swift in cutting losses in this kind of stocks

Test for Outstanding Shares:

There is not an objectively ideal number of outstanding shares, but here is a rule of thumb:

• Criterion 7: The number of the outstanding stocks should be best between 3 to 7 millions. Otherwise, it should be under 30 million shares.

Companies with more number of shares, or frequent splitting of stocks, tend to hurt the momentum of the stock.

L: Leaders of Industry.

One key idea in the CANSLIM philosophy is to only buy the best stocks. O’Neil devises the following tests on the leadership of a stock.

Test for Relative Strength:

Relative strength (RS) is indicator calculated by comparing the movements between a stock and a benchmark index (e.g. S&P 500) within a time period (e.g. one year). If the indicator says a strength number of 90, then it means the stock, since a year ago, is outperforming the benchmark for 90% of the time. Here is the criterion:

• Criterion 8a: The stock must have a RS of at least 80, or better, larger than 90.

If you are lazy, you can pretty much figure out this by simply using your eyes. Say, if the stock is going up while the general market is falling slightly down, then it has probably passed the test.

Test for Relative Strength of Cousin Stock:

The RS test also applies to the close competitor of a stock, because O’Neil believes that a stock is reliable only if the whole industry is stronger than the general market. Here it goes:

• Criterion 8b: At least one other stock in the same industry must have a RS of 80.

Again, this could be pretty much solved by using your eyes.

Test for Industry Relative Strength:

It is also important to apply RS to an ETF (or a performance index)of the industry, like Utilities Select Sector SPDR Fund (XLU) for utilities. Here is the criterion:

• Criterion 8c: The RS of the industry ETF must be at least 70, or at least 15% of the stocks in the industry are around yearly high.

The idea is to make sure that the strength of the stock is supported by the overall macroeconomic force in the industry.

Test for Momentum Relative to Benchmark:

It is important to know that the stock is still having an advantage in momentum versus the benchmark.

• Criterion 9: The percentagewise change in price of the stock in the latest 4 months must be greater than that of the selected benchmark in the same period.

O’Neil said a 4-month period is selected because it eliminates the quarterly seasonal factor.

I: Institutional Support.

Test for Institutional Ownership:

O’Neil considers institutional investment a good thing, because he thinks that professionals usually do a lot of research before investing. 

• Criterion 10: There must be at least 5 unrelated institutional investors, and 10 is a reasonable number.

Another advantage of having institutional investors is that they provide the necessary liquidity when you want to get out.

Test for Quality of Ownership:

Insider investment into the company is a good sign because it means that they are willing to risk their own fortune in the company. 

• Criterion 11: Institutional ownership must be increasing over the past years, and at least one of them shows a good track record in his fund.

However, O’Neil also warned that when a company is over-owned, i.e. too many institutional investors, it may be a sign of topping out.

M: Market Direction.

As a general rule, one must follow the general market direction, i.e. no buying in a bear market, and no short-selling in a bull market. O’Neil has developed some ways to identify the general market direction, but the size of information is beyond the limit of the present article. Please refer to his book How to Make Money in Stocks for more details.

On When to Buy and Sell

Unlike many other gurus, O’Neil emphasizes on timing and believes that the best time to buy is when the stock just takes off from a sound consolidation period, which he calls a “base”. To him, a sound base has three features: firstly, it has a low percentagewise change in range; secondly, there is great buying volume prior to the breakout; and finally, it usually forms a certain kind of chart patterns. For more information, please refer to his book How to Make Money in Stocks.

He also believes in a profit-taking plan, that you should cut losses at about 7% below your buying level, and taking profit when the stock rose for above 20%-25%. Again, for details and exceptions of this rule, please refer to his book.

Summary

In conclusion, there are 9 things you should look at before investing in the CANSLIM way:

Accounting Criteria:

• Quarterly EPS: 
• Increased by 18% of last quarter, and
• Increased by 50% of last yearly quarter.
• Quarterly Sales:
• Increased by 25% of last quarter, or
• Steady increase over last 3 quarters.
• Similar growth in at least one competitor.
• Annual compounded EPS: 
• Increased by 18% of last year, and
• Only one dip in 5 years.
• Return on equity:
• At least 17%.
• Long-term debt to equity ratio:
• Less than 2%, or
• Decreasing in the last 3 years.

Background Criteria:

• Number of shares outstanding:
• Best less than 7 million, or
• No greater than 30 million.
• Buying level:
• At least 85% no previous high.
• Institutional and Ownership Holdings:
• At least 10 institutional holdings, and
• An increasing trend for institutional holdings.
• Relative strength:
• At least 80 for the stock and one other stock in the same industry.
• At least 70 for the industry ETF, or 15% constituents at new high.
• Four-month momentum greater than benchmark.

Please note that there are no perfect stocks in the world: if a stock can satisfy 80% of the criteria above, it is already very good, especially when it comes to the lesser ones like outstanding shares and long term debt levels. Coupled the above with proper money management technique, it is not that complicated to make big money in the stock market.