Bill O'Neil, founder of Investor's Business Daily, is one of the most important thinkers to come out of investing in the last 30 years. His CAN SLIM™ methodology for evaluating stocks has become one of the most enduring systems for making money in the stock market. O'Neil bought a seat on the New York Stock Exchange at age 30 and his investment research company, William O'Neil & Co., counts among its clients hundreds of the top institutional investment firms in the U.S. and worldwide. The Motley Fool's Senior Editor for Investing, Bill Mann (TMF Otter), interviewed O'Neil on June 10, 2002, ahead of the release of the third edition of his national bestseller How to Make Money in Stocks. This is the second installment of the interview.
TMF Otter: One of the key points of your investing methodology is that one should pay close attention to the strength of the overall market, and then to the best-performing industry groups. Why is that preferable in your mind to simply buying top-tier companies when they're inexpensive and waiting out a bad market? Where should you focus?
Bill O'Neil: It pays to concentrate in the top 10% or so of industry groups in recent performance or the top six or seven broader sectors for company selections. Since the most recent market bottom in the Dow Jones Industrials in September 2001, the leading groups -- the ones that have generated the highest returns -- have been defense stocks, homebuilders, medical and healthcare, leisure and gaming, and smaller-cap, unique consumer-oriented, companies in retailing, restaurants, and banking.
Some of these stocks have held IPOs [initial public offerings] within the last 10 years. But interestingly, former high-tech leaders have been the poorest-performing sector, which means that many people who are waiting out a rebound in tech are missing an ongoing rebound in other sectors.
It should be noted that Wall Street completely missed the homebuilders as a group with strong potential. Most leading firms all downgraded the group in the spring of 2001, saying they should be sold and that strength in housing sales couldn't last. The better housing stocks have since then doubled. Housing analysts gave costly advice.
TMF Otter: Your point about poor performance from Wall Street reminds me of a question I got awhile ago about whether following analyst recommendations was profitable. "Profitable for whom?" It's tough to describe to people that some of their preconceived notions about what makes a good company are nothing but notions -- and following analysts can be pretty damaging. Give us some of your hard-and-fast rules for selecting stocks.
O'Neil: I have always avoided low-quality companies. As a rough definition, I place any company with a price below $10 in this category. You won't get the same quality of sponsorship behind these companies that you do in true market leaders.
TMF Otter: I thought you just said that analysts are not to be followed.
O'Neil: That's not what I mean by sponsorship. Sponsorship in this case is ownership by institutional investors. Let's face it, they move the market when they make buy or sell transactions -- they are the big money. Many mutual funds and pensions have limitations against buying stocks that are below a certain threshold, starting at $10. Why try to fight upstream with a company that the big money can't buy?
Also, don't pick your stocks because of dividends, book value, or P/E ratios. Buy the leading company in a leading sector with high earnings and sales growth, return on equity, profit margins, and product superiority.
TMF Otter: We have heard legions of stories at this point about companies that are cooking their books and that earnings aren't to be trusted. Is that why you would ignore P/E?
O'Neil: Not quite. We have found that P/E is a poor predictor of a stock that is going to go much higher. Usually great companies have high P/Es. People are excited about these companies for a reason, just like a low P/E indicates that people are not excited about a company. Our research shows that most of the companies that had the best performance in the stock market started big runs with high earnings multiples.
TMF Otter: So an advancing P/E is unimportant to you in terms of determining when to sell as well?
O'Neil: Although I don't advocate over-focus on P/E, I do know that it generally provides me with a general idea of the expectations of the market as to future growth. If I disagree, I sell.
You absolutely must learn, write down, and follow some specific sell rules on when to best sell and take a profit on the way up while a stock is still advancing and popular. For example: If your stock breaks out of a sound price base structure and advances for many months and, on top of that, then runs up in price for one or two weeks at a much faster rate than in any other prior weeks since the beginning of the move up, this is a climax top, and the stock should always be sold while everyone else is all excited by the exceptionally strong price action. Typically, one day in this climax period will be up more points than any other day in the whole move up. Sell, get out while you can, and nail down your profit.
TMF Otter: If you pick a great stock with good value in the first place, shouldn't it hold up and outride the downdraft? Personally, if I feel like a stock is underpriced, I don't care what it does from a price standpoint in the interim.
O'Neil: How many times have you been wrong? When a stock is dropping, that's what the market is telling you -- "you're wrong." There are plenty of people who thought that Enron was severely underpriced at $30. Everyone needs sell rules, otherwise you're not being realistic. Nothing lasts forever. The big leaders in one market cycle do not normally come back and lead in the next bull market cycle. If you want to learn more about when to sell or how to create a realistic set of sell rules to improve your investment results, that includes being prepared to not fight the market. It doesn't care what you think about a company, or what you paid for it.
Recognize this about the stock market -- it is a wonderful example of psychology on parade. It's a matter of historical fact that 82% of the best-performing stocks over the last 50 years had a blow-off top before they started coming down. I don't know about you, but if I saw something that happened 82% of the time, I'd pay attention. The things you read about in How to Make Money in Stocks aren't my opinion -- they're based on what has happened in the past. Because human psychology does not change, there is a great probability that they will happen again in the future. If you're an investor, putting probability on your side is in your best interest.
TMF Otter: Mr. O'Neil, thanks so much with your time.
O'Neil: My pleasure.
Read Part 1 of this interview.
Want to learn more about Bill O'Neil's investing philosophy? Investor's Business Daily can put some great investing tools right in your lap every day. And you can get 10 days of IBD plus our interactive "Fool's Guide to Using IBD" -- all free. Just sign up. It's part of What Every Fool Needs.