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� Learn...the seven step CANSLIMTM system for findingwinning stocks, based on astudy of the most profitablestocks for each year datingback to 1953.

� Enhance...your wealth by avoidingthe 19 mistakes that keepmost investors from enjoy-ing better returns.

� Understand...how you can use key mea-sures such as a stock’s earn-ings per share to pick stocksthat are ready to soar.

� Discover...the truth behind price-earnings ratios, and why itcan sometimes be wiser tobuy stocks with high P/Eratios instead of those withlow ones.

� Realize...that you can make big prof-its by buying a stock whenit is selling at a new high,instead of buying stockthat has hit a new low.

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How to Make Money in StocksA Winning System in Good Times or Bad

Third Editionby William J. O’Neil

A summary of the original text.

We live in a fantastictime of unlimited oppor-

tunity, an era of outstandingnew ideas, emerging indus-tries, and new frontiers.Brilliant technologies, newsoftware, advances in geneticengineering, and innovativebusiness models all createnew opportunities to makewealth in the stock market.

But to find the right stocks— the ones that will makemoney — you have to followa proven, disciplined systemfor success in both good andbad markets.

Many people who invest inthe stock market eitherachieve mediocre results orlose money because they lackknowledge. But there's noexcuse for poor performance.With the rules you will learnin this summary, you candefinitely learn how to pickbig winners in the stockmarket and become partowner of the best companiesin the world.

All you need to remember is aproven, simple, fact-basedsystem called CAN SLIMTM.The system consists of rulesfor buying and selling stocksthat is derived from an exten-sive analysis of all of thegreatest winning stocks eachyear for the last half-century.

Each letter in the words CANSLIM stands for one of theseven chief characteristics ofthese greatest winning stocksat their early stages, justbefore they made huge profitsfor their shareholders.

We'll soon explore each ofthese characteristics indetail, but let's get startedright now with a preview ofCAN SLIM:

• C is the first letter inCurrent QuarterlyEarnings per Share:The higher, the better.

• A stands for AnnualEarnings Increases:Look for significantgrowth.

Volume 11, No. 8 (2 sections). Section 2, August 2002© 2002 Audio-Tech Business Book Summaries 11-16.No part of this publication may be used or reproducedin any manner whatsoever without written permission.

To order additional copies of this summary, referenceCatalog #8022.

• N is short for NewProducts, NewManagement, New Highs:Buy at the right time.

• S refers to Supply andDemand: Look forshares outstanding, plusbig volume demand.

• L refers to Leader orLaggard: Determinewhich category yourstock is in.

• I is short forInstitutionalSponsorship: Follow theleaders.

• M represents MarketDirection: You need to beable to determine it.

The reason that CAN SLIMcontinues to work, cycle aftercycle, is because it is basedsolely on the reality of howthe stock market actuallyworks, rather than personalopinions, including those ofthe experts on Wall Street.Further, human nature atwork in the market simplydoesn't change. So CANSLIM does not get outmodedas fads, fashions, and economic cycles come and go.

How have these disciplinedbuy-and-sell rules performedin good and bad markets?The American Association ofIndividual Investors com-pared the CAN SLIM systemto other well-known methodsof selecting stocks, such asthose of Peter Lynch, WarrenBuffett, and many others.The comparison included thebull market years of 1998and 1999, as well as the bearmarket of 2000.

Their independent study,published in 2001, found thatCAN SLIM had the best andmost consistent performancerecord each year. The resultswere a 28.2 percent returnfor 1998, 36.6 percent for1999, and an astonishing30.2 percent during the dis-astrous market of 2000 thatruined the portfolios of manyother investors.

Now, let's explore how youcan put the CAN SLIM sys-tem to work in enrichingyour own portfolio.

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C = CURRENT QUARTERLYEARNINGS PER SHARE

Let's start with the C in CANSLIM: Current QuarterlyEarnings per Share.

If you look down the list ofthe market's biggest winnersover the past 50 years, you'llinstantly see the relationshipbetween booming profits andbooming stocks. Considerthese recent examples:

• Cisco Systems postedearnings-per-share, orEPS, gains of 150 percentand 155 percent in thetwo quarters endingOctober 1990, prior to its1,467 percent price run-up over the next threeyears.

• Accustaff showed a 300percent profit increasejust before its price gainof 1,486 percent in the 16months from January1995.

• Ascend Communications

saw earnings up 1,500percent in August 1994,just prior to its 1,380percent price move overthe next 15 months.

In fact, of all the characteris-tics that O'Neil studied, nonestood out as boldly as theprofits each big winnerreported in the latest quarteror two before its major priceadvance. In his models ofthe 600 best-performingstocks from 1952 to 2001,three out of four showedearnings increases averagingmore than 70 percent in thequarter before they begantheir major advances. Theremaining 25 percent did sothe very next quarter andhad an average earningsincrease of 90 percent.

Here is the rule to remem-ber: The stocks you selectshould show a major percent-age increase in the mostrecently reported quarterlyearnings per share, relative tothe prior year's same quarter.

The EPS number is calculat-ed by dividing a company'stotal after-tax profits by thenumber of common sharesoutstanding. This percentagechange in EPS is the singlemost important element instock selection today. Thebigger the increase, the bet-ter. There is absolutely noreason for a stock to go any-where good if earnings arepoor.

Following the CAN SLIMstrategy's emphasis on earn-ings ensures that an investorwill always be led to thestrongest stocks in any mar-ket cycle, regardless of any

2 A U D I O - T E C H

temporary, highly speculative"bubbles" or euphoria. Butremember, don't buy on earn-ings growth alone. We'llcover the other key factorslater in this summary.

It's important to watch outfor misleading earningsreports. A company mayreport record sales of $7.2million versus $6 million, foran increase of 20 percent forthe quarter just ended. Thecompany also had recordearnings of $2.10 per share,up 5 percent from $2.00 pershare for the same quarter ayear ago. Consider: Why aresales up 20 percent but earn-ings up only 5 percent. Whathappened to the company'sprofit margins — and why?

The key question for the win-ning investor must always be:

How much are the currentquarter's earnings per shareup, in percentage terms, fromthe same quarter the yearbefore?

Furthermore, always com-pare earnings for the sameperiod year-to-year, notsequential quarters, whichcan cause distortion. Inother words, don't comparethe earnings from theDecember quarter to thosefrom the September quarter.Rather, compare theDecember quarter from thisyear to the December quarterof last year for a more accu-rate evaluation. Also, avoidthe trap of being influencedby nonrecurring profits.Ignore the earnings thatresult from extraordinary,one-time gains, such as thesale of real estate.

Whether you're a new orexperienced investor, avoidbuying any stock that doesnot show EPS up at least 18to 20 percent in the mostrecent quarter versus thesame quarter the year before.To be even safer, insist thatboth of the last two quartersshow significant earningsgains.

Keep in mind that strong,improved quarterly earningsshould always be supportedby growth in sales. Look forgrowth of at least 25 percentfor the latest quarter, or atleast acceleration in the rateof sales percentage improve-ment over the last threequarters.

Some professional investorsbought Waste Managementat $50 in early 1998 becauseearnings had jumped threequarters in a row, from 24percent to 75 percent to 268percent. This seemed a clearsignal to buy the stock, untilone considered the company'ssales, which increased onlyby 5 percent. Several monthslater, the stock collapsed to$15 a share.

What this demonstrates isthat earnings can be inflatedfor a few quarters by cuttingcosts in such areas as adver-tising or R&D. To be sus-tainable, earnings growthmust be supported byincreases in sales. Such wasnot the case with WasteManagement.

You now know the first criti-cal rule for selecting winningstocks: Current earnings pershare should be up signifi-cantly — at least 25 percent

or more — over the sameperiod for the previous year.The best companies mightshow earnings increases of 100 percent to 500 percentor more. A mediocre 10 or 12percent is not enough. Whenpicking winning stocks, it'sthe bottom line that counts.

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A = ANNUAL EARNINGSINCREASES

Any company can report agood earnings quarter everyonce in a while. As we'vediscussed, strong currentquarterly earnings are criti-cal to picking most of themarket's big winners. But itis not enough.

To ensure that current earnings aren't just a flashin the plan, you must insiston more proof. The way todo that is by reviewing thecompany's annual earningsgrowth rate, which is repre-sented by the letter A inCAN SLIM.

Look for annual earnings pershare that have increasedevery year for the past threeyears. You normally don'twant the second year's earnings down, even if the fol-lowing year rebounds and isin new high ground. It is thecombination of strong earn-ings in the last few quarters,plus a record of solid growthin recent years, that creates asuperb stock.

To find winning stocks, selectcompanies with annual earn-ings growth rates of 25 percent, 50 percent, or even100 percent or more.

B U S I N E S S B O O K S U M M A R I E S 3

Between 1980 and 2000, themedian annual growth rateof all outstanding stocks inthe study was 36 percent attheir early emerging stage.A typical EPS progression forthe five years preceding thestock's major move might besomething like $0.70, $1.15,$1.85, $2.65, and then $4.00.

It might be acceptable to haveone down year if the followingyear's earnings quickly recov-er and move back to new highground. However, a movefrom $4.00 to $5.00, to $6.00,then to $2.00 and $2.50 wouldnot be acceptable. Eventhough the fifth year pro-duced a significant increaseover the fourth year, thatincrease is still considerablybelow previous years.

Also, you should not ignore acompany's annual return onequity. The greatest winningstocks of the past 50 yearshad ROEs of at least 17 per-cent. Return on equity helpsseparate the well-managedfirms from the poorly man-aged ones. Additionally, lookfor growth stocks that showannual cash flow per sharegreater than actual EPS byat least 20 percent.

The stability of earnings isalso important. Check thepattern for at least threeyears. The stability measure-ment that O'Neil developeduses a scale of 1 to 99. Thelower the number, the morestable the past earningsrecord.

The figures are calculated byplotting quarterly earningsfor the past five years, andfitting a trend line around

the plot points to determinethe degree of deviation fromthe basic trend.

Growth stocks with steadyearnings tend to show a stability figure below 20 to 25. Companies with sta-bility numbers over 30 aremore cyclical and a little less dependable in terms of growth. These figures are usually shown immedi-ately after the company'sannual growth rate on mostinvestment services.

If you restrict your stockselections to companies with proven growth records,you will avoid the hundredsof investments with erratichistories.

Emphasizing three-yearannual EPS criteria will helpyou to weed out 80 percent ofthe stocks in any industrygroup. Earnings per shareshould be excellent for bothcurrent periods and for athree-year period to warrantserious consideration as aninvestment.

The fastest way to find acompany with strong andaccelerating current earningsand three-year growth is bychecking the EPS rating pro-vided for every stock listed inInvestor's Business Daily.The EPS Rating is defined asa measure of a company'stwo most recent quarters'earnings growth rate, com-pared to the same quartersone year prior. Then, thecompany's three-year annualgrowth rate is examined.

The results are compared to all other publicly traded

companies and rated on ascale of 1 to 99, with 99 beingbest. An EPS Rating of 99means a company has outper-formed 99 percent of all othercompanies in terms of bothannual and recent quarterlyearnings performance.

But what about price-earningsratios? Are they really impor-tant? Prepare yourself for abig surprise.

P/E ratios have been used foryears by analysts as theirbasic measuring tool todecide if a stock is underval-ued and should be bought, orovervalued and should besold. However, O'Neil'sanalysis of the most success-ful stocks from 1952 to thepresent shows that P/Eratios were not a relevantfactor in price movement andhave very little to do withwhether a stock should bebought or sold.

P/Es are an end effect, not acause. To say a stock is"undervalued" because it is selling at a low P/E is nonsense. It is much morecrucial to look at whether therate of change in earnings issubstantially increasing ordecreasing.

From 1953 to 1985, the aver-age P/E ratio for the best-performing stocks at theirearly emerging stage was 20.At the time, the average P/Eof the Dow Jones IndustrialAverage was 15. Whileadvancing, the biggest win-ners expanded their P/Es by125 percent to about 45.During the 1990-95 period,the real leaders began withan average P/E of 36 and

A U D I O - T E C H4

expanded into the 80s. Sincethese are averages, thebeginning P/E range for mostbig winners was 25 to 50,and the P/E expansions var-ied from 60 to 115. The late1990s market euphoria sawthese valuations increase toeven greater levels. Valuebuyers missed all of thesetremendous investments.

If you were not willing to payan average of 25 to 50 timesearnings, or even much more,for growth stocks, you automatically eliminatedmany of the best investmentsavailable. You would havemissed out on Microsoft, CiscoSystems, Home Depot, andAmerica Online during theirperiods of greatest marketperformance.

The lesson is this: In a roaring bull market, don'toverlook a stock just becauseits P/E seems too high. Itcould be the next great stockmarket winner.

Another faulty use of P/Eratios is to evaluate stocks inan industry and concludethat one selling at the cheap-est P/E is undervalued andtherefore the most attractiveone to buy. The reality isthat the lowest P/E usuallybelongs to the company withthe most ghastly earningsrecord, and that's preciselywhy it sells at the lowest P/E.

The simple truth is thatstocks generally sell neartheir current value, based oneconomic conditions, earn-ings, events, and psychology,which are reflected in theP/E ratio. A stock that sellsfor 7 times earnings does so

because its overall record ismore deficient than one witha higher P/E ratio.

In situations where smallgrowth companies have revo-lutionary new products, whatseems like a high P/E ratiocan actually be low. Consider:

• Xerox sold for 100 timesearnings in 1960 —before it advanced 3,300percent in price.

• Syntex sold for 45 timesearnings in July 1963 —before it advanced 400percent.

• Genentech was priced at200 times earnings inNovember 1985, and itincreased 300 percent infive months.

• America Online sold forover 100 times earningsin November 1994 beforeincreasing 14,900 percentfrom 1994 to its top inDecember 1999.

These companies had fantas-tic new products: the firstdry copier, the oral contracep-tive pill, the use of geneticinformation to develop newwonder drugs, and access tothe revolutionary new worldof the Internet. If you had abias against P/Es you consid-ered too high, you would havemissed out on the tremendousprice advances these stocksmade.

In other words: Don't sellhigh P/E stocks short.Follow the second criticalrule: Concentrate on stockswith proven records of signif-icant earnings growth in each

of the past three years, plusstrong recent quarterlyimprovements. Don't acceptanything less.

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N = NEW PRODUCTS, NEWMANAGEMENT, NEW HIGHS

How do dramatic advances ina stock’s price occur?Inevitably it’s the result ofsomething new to the exist-ing business. This is the N inCAN SLIM: new products,new management, and newhighs.

In the study of the greateststock market winners from1952 through 2001, morethan 95 percent of stunningsuccesses met at least one ofthese three criteria. It can beremarkable new products orservices that cause a surge insales and profits. It can benew management that bringsnew vigor and new ideas anda new beginning to the orga-nization. Or new conditions,such as shortages, priceincreases, or revolutionarytechnologies, can affect moststocks in an industry groupin a positive way.

The number of new productsthat have made a dramaticimpact on companies’ earn-ings is almost too numerousto mention, but here are justa few:

• Rexall’s new Tupperwaredivision in 1958 pushedthe company’s stock from$16 to $50 per share.

• McDonald’s, with its newapproach to low-priced,fast food franchising,

B U S I N E S S B O O K S U M M A R I E S 5

exploded 1,100 percentfrom 1967 to 1971.

• Amgen developed twosuccessful biotech drugsin 1991 and 1992 and thestock went from $60 in1990 to the equivalent of$460 in 1992.

• Dell Computer, theleader in built-to-orderdirect mail computersales, advanced 1,780percent from November1996 to January 1999.

The issue for all of thesestocks was picking the tim-ing of that breakout priceadvance. As mentioned pre-viously, be suspicious ofshort-term spikes in earn-ings. They can be the resultof "cost savings" that harmlong-term innovation.

O’Neil explains another char-acteristic found in the earlystages of all winning stocks:the "great paradox." Manybuyers are more comfortableto "buy low and sell high."Among the hundreds of thou-sands of investors whoattended his investment lec-tures over the past threedecades, 98 percent say theydo not buy stocks that arereaching new highs in price.Most institutional investorsare also "bottom buyers" thatprefer to buy stocks that areselling near their lows.

The study of the greateststock market winners provedthat the "buy low, sell high"strategy is completely wrong.In fact, the analysis provedthe exact opposite: Whatseems too high in price andrisky to the majority usually

goes higher, and what seemslow and cheap usually goeslower.

A second study yielded thesame conclusion. O'Neil ana-lyzed two groups of stocksover many market periods:those that made new highs,and those that made newlows. The results were conclusive: Stocks on thenew-high list tended to gohigher in price, while thoseon the new-low list tended togo lower.

Rather than buy such low-priced "bargains," aninvestor usually would besmart to avoid them. A stockmaking the new-high listmight offer great returns,especially if it is trading onbig volume during a bullmarket.

The trick is being able to iden-tify those stocks that, despitereaching a new high, areready to really break out ofpast patterns. For example,in 1990 the investor whobought Cisco Systems at its"scary" new high, the highestprice in its history, enjoyed anearly 75,000 percent increasefrom that point forward.

The issue is timing. The per-fect time to buy is during abull market just as the stockis starting to break out of itsprice base. This is the"pivot" or buy point.

In conclusion: Look for com-panies that have developedimportant new products orservices, or have benefitedfrom new management, ornew industry conditions.Then buy their stocks when

they are emerging from price consolidation patternsand are close to, or actuallymaking, new highs.

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S = SUPPLY AND DEMAND

Now let's move on to the S inCAN SLIM: Supply andDemand, or shares outstand-ing plus big volume demand.

The law of supply anddemand determines the priceof almost everything in life,including stocks. The priceof a common stock with 5 bil-lion shares outstanding isharder to budge becausethere's a large supply. Ittakes a large volume of buy-ing, or demand, to create asignificant price increase.

On the other hand, if a com-pany only has 50 millionshares outstanding, just asmall amount of buying, ordemand, can push the priceup more rapidly. This meansthat if you are choosingbetween two stocks to buy,the one with the fewer shareswill usually be the better performer, if other factors areequal.

However, since smaller-capstocks are less liquid, theycan come down as fast asthey go up — sometimeseven faster. In other words,with greater opportunitycomes greater risk.

In general, large-cap compa-nies offer some advantages:greater liquidity, less down-side volatility, better quality,and usually less risk. Theimmense buying power of

6 A U D I O - T E C H

large funds can make a bigstock advance as fast asshares of a smaller firm.

However, large companies canalso suffer from a lack ofimagination. They are typi-cally less willing to innovate,take risks, and keep up withthe times. Most new productscome from young, hungry,innovative, small- and medi-um-sized companies withentrepreneurial management.Not coincidentally, these busi-nesses, often in the serviceand technology industries,tend to grow much faster andcreate most of the new jobs.

There are two other signs tolook for regarding supply:

• First, look for companiesthat are buying backtheir own stock. In most,though not all cases, thisis a good sign. Thismeans that there will befewer shares outstandingand that earnings pershare — one of the prin-cipal driving forcesbehind outstandingstocks — will be higher.

• Second, low corporatedebt-to-equity ratio isgenerally better. Suchcompanies are not vul-nerable to interest ratespikes that can harmearnings.

Any type of stock, from small-cap to large-cap, can bebought under the CAN SLIMmethod. However, small cap stocks will be moreattractive as break-out invest-ments. Just be aware thatthey are substantially morevolatile, both on the upside

and downside. From time totime, the market will shift itsemphasis from small to largecaps, and vice versa.

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L = LEADER OR LAGGARD?

People tend to buy stocksthey like, or stocks thatmake them feel comfortable.But in a bullish stock mar-ket, these sentimental picksoften lag the market ratherthan lead it. This brings usto the L in CAN SLIM —determining whether thestock is a leader or a laggard.

Suppose you buy a stock inthe computer industry. Ifyou buy the leader in thegroup, and your timing isright, you have a chance atreal price appreciation.

But if you buy a stock that isat the bottom of the pile,because you think you aregetting a bargain, you mighthave bought a stock with lit-tle upward price potential.Why else would it be so farbehind the pack?

The two or three leaders inan industry group can haveunbelievable growth whilethe rest of the industry lan-guishes. Home Depotadvanced 10 times from 1988 to 1992, while Wabanand Hechinger, the group'slaggards, dramaticallyunderperformed.

Buy the leaders, not the lag-gards. All of the big winnerswere the No. 1 companies intheir industries at the timethey were purchased. Thesecompanies included Syntex

in 1963, Price Company from1982 to 1985, Genentechfrom 1986 to 1987, andCharles Schwab from 1998and 1999.

The market leader isn’t nec-essarily the biggest companyor the one with the most recognized brand name. It’sthe one with the best quar-terly and annual earningsgrowth, return on equity,profit margins, sales growth,and price action. It alsooffers a superior product orservice, and is gaining mar-ket share from its older, lessinnovative competitors.

O'Neil's research clearlyshows that you should avoid"sympathy" stocks. A sympa-thy stock is a stock in thesame group as a leading com-pany and is bought in thehope that the leader’s lusterwill rub off "in sympathy."These companies tend to pro-duce copycat products, butdon’t deliver on the results.People buy these stocksbecause they are cheaper, butthe lower price usually islower for a good reason — itreflects the earning power ofthe company and, thus, itsstock.

There's a fast and easy wayto tell if a stock is a leader ora laggard: Use the RelativePrice Strength Rating, or RSRating. The RS rating isdefined as:

A proprietary rating thatmeasures the price perfor-mance of a given stockagainst the rest of the marketfor the past 52 weeks. Eachstock is assigned a perfor-mance rating from 1 to 99,

B U S I N E S S B O O K S U M M A R I E S 7

with 99 being the best. AnRS rating of 99 means thatthe stock has outperformed99 percent of all other companies in terms of priceperformance.

If a stock’s RS rating isunder 70, it is lagging thebetter-performing stocks inthe market. That doesn’tmean it can’t increase inprice, just that it probablywill go up less.

The average RS rating of thebest-performing stocks eachyear from the early 1950sthrough 2000 was 87 beforetheir major run-ups. So therule for winners is: Avoidlaggard stocks and sympathymoves, even if they look tan-talizingly cheap. Focus onthe market leaders!

The RS Rating for all NYSE,NASDAQ, and Amex stocksis listed each day inInvestor's Business Daily.Updated RS Ratings are alsofound on the Daily GraphsOnline charting service.

To upgrade your stocks andconcentrate on the leaders,restrict your purchases tocompanies that have an RS Rating of 80 or higher.Many of the big money-making selections have RSratings of 90 or higher beforebreaking out to higher priceappreciation.

You can find new leaders in amarket downturn by watch-ing the decline percentages.The more desirable growthstocks correct 1 1/2 to 2 1/2times the general marketaverage. In a bull market,growth stocks declining the

least are generally the bestselections. The higher thedecline, the less desirable.

Once a general marketdecline is over, the firststocks that bounce back tonew price highs are almostalways the true leaders.

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I = INSTITUTIONALSPONSORSHIP

Now we're ready to discussthe I in CAN SLIM:Institutional Sponsorship.This refers to the shares ofstock owned by investmentgroups, such as mutualfunds, pension funds, banks,and so on.

It takes big demand to moveprices up, and by far thelargest source of big demandare the institutionalinvestors who account for thegreatest share of each day'smarket activity.

A winning stock doesn’t needto have a huge number ofsuch investors, but it shouldhave at least 10. If a stockhas none, chances are likelythat its performance will berun-of-the-mill.

The next important assess-ment is the quality of theinstitutional owners: Howmany, if any, of the best port-folio managers own thestock? Look for stocks heldby at least one or two of themore savvy portfolio man-agers who have the best per-formance records. You canconsult a fund’s 36-MonthPerformance Rating inInvestor’s Business Daily; an

A+ rating indicates a fund isin the top 5 percent of allfunds for performance. Manyother financial services alsopublish performance recordsof various institutions.

In general, buy companiesthat show an increasingnumber of institutional owners over several recentquarters. A metric inInvestor's Business Daily,called the SponsorshipRating, ranges from A, forbest, to F, for worst. Stockswith an A rating indicateincreased buying by the bet-ter money managers in themarket.

It is, of course, possible tohave too much institutionalsponsorship. Stocks can be"overowned" by institutionsand such excessive owner-ship can translate into large-scale selling if somethinggoes wrong with a stock.The result can be not just acorrection, but a calamity ifone institution sells, say, 500million shares of a companyin one transaction.

The rule for wise investors isto only buy stocks that haveat least a few institutionalsponsors with better-than-average recent performancerecords, and invest in stocksshowing an increasing totalnumber of institutional owners in recent quarters.

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M = MARKET DIRECTION

Finally, the last characteris-tic of the greatest winningstocks is market direction,the M in CAN SLIM.

8 A U D I O - T E C H

You can be right about eachof the six previous factors,but if you're wrong about thedirection of the general mar-ket, three out of four of yourstocks will plummet with themarket averages, and youwill certainly lose big moneyas many people did in 2000.Therefore, you absolutelymust have a reliable methodto determine if you're in abull or bear market.

The best way to determinethe direction is to follow,interpret, and understandwhat the general marketaverages are doing every day.The general market refers tothe most commonly usedmarket indices: the DowJones Industrial Average, theS&P 500, and the NASDAQComposite.

Watch recent market cyclesto get a sense of length andcharacter of the current mar-ket. Examine the generalmarket trends daily to spotreverses that signal a changein direction. Typically, inbear markets, stocks openstrong and close weak. Inbull markets, they openweak and close strong. It isimportant to sell when thegeneral market tops. Thiswill protect your gains andgive you liquidity to buylater.

Don’t be seduced by the mythof long-term investing. Theidea of buying and holdingthrough thick and thin intu-itively appeals to most peo-ple’s sense of stability. If theprice of a good company goesdown during a general bearmarket, it will come backwhen the next bull market

takes over. Right? Yes, butstocks don’t lose value at thesame rate and they don’trecover at the same pace orto the same degree.

If you use stop orders, youwill automatically be forcedout of many of your stocks ina market that is beginning totop out. It’s usually betternot to use stop-loss ordersbecause you are tipping yourhand to market makers. Attimes, they might drop thestock to shake out stop-lossorders. Instead, if possible,follow your stocks closely andknow the exact price at whichyou will immediately sell tocut a loss. If you are too busyto watch your stocks closely,stop-loss orders can protectyou against big losses.

You can detect a market topby watching the major indicesas they work their way high-er. On one of the days in theuptrend, volume will increasefrom the day before, but theaverages will close either flator down, and certainly withless increase than the previ-ous day. If the average doesin fact close down, it will beeasier to spot the selling byprofessional investors as theyliquidate their positions. Thespread from the day’s high toits low might be a little widerthan on previous days.

Normal liquidation near themarket peak will usuallyoccur on three to five daysover one, two, or three weeks.In other words, the sellingoccurs while the market isstill advancing.

After four or five days of definite selling, the general

market will almost alwaysturn down. Sometimes thiscan occur over six to sevenweeks. If you cut your lossesand sell at 7 to 8 percentbelow your buy points, youalways will be forced to sellat least some stocks as a cor-rection in the general marketbegins to develop. Equallyimportant, this approachgets you into a defensive,questioning frame of mindsooner. Following this sim-ple rule saved a lot of peoplebig money in the devastatingdecline in technology stocksduring 2000.

Shifts in market direction canalso be detected by reviewingthe last four or five stock pur-chases in your own portfolio.If you haven’t made a dime onany of them, you could bepicking up on a trend.

Another sign of a top is thestrengthening of low-priced,low-quality stocks. This is asignal that the upward mar-ket is near its end. A down-turn eventually takes downall stocks, both the leadersand followers. If the leaderscan’t lead, it isn’t reasonableto expect the laggards to han-dle the job. A topping marketcan even recover for a coupleof months and get near oreven above its old high beforebreaking down.

The next question to analyzeis: How far is down? Whencan you spot a market bot-tom? A rally attempt beginswhen a major market aver-age closes higher after adecline, either from earlier inthe day or the previous ses-sion. On the fourth day ofthe attempted rally, look for

B U S I N E S S B O O K S U M M A R I E S 9

one of the major averages to"follow through" with a 2percent or more gain onheavier volume than the daybefore. The most powerfulfollow-throughs usually occuron the fourth to seventhdays. The follow-throughshould be explosive, with a 2percent or more gain onheavy volume.

A follow-through doesn’tmean you should buy withwild abandon. It is a signalthat it is OK to buy qualitystocks, and it is a vital con-firmation that the attemptedrally is succeeding. No bullmarket ever started withouta strong price and volumefollow-through confirmation.

The time to capitalize on theopportunities is during thefirst two years of a normalbull market cycle. The rest ofthe up cycle usually consistsof back-and-forth movementin the market averages followed by a bear market.

There are several additionalways to identify key marketturning points:

1. Look for divergence of keyaverages. If they aremoving in opposite direc-tions, or in the samedirection but at very dif-ferent rates, it could be aturning point. If forexample, the Dowadvances significantlybut the S&P 500, a muchbroader-based index, doesnot, it could mean a keyturning point is at hand.

2. Study psychological indi-cators of the market'sdirection. The percentage

of investment adviserswho are bearish is aninteresting measure ofinvestor sentiment. Inshort, the majority isusually wrong. Similarly,the short-interest ratio,the amount of shortinterest selling on theNew York StockExchange, can reflect thedegree of bearishnessshown by speculators.

3. Watch Federal ReserveBoard rate changes.Among fundamental gen-eral market indicators,the Fed’s discount rateand the Fed Funds rateare valuable indicators to watch. For example,three successive hikes in the discount rate have generally markedthe beginning of bearmarkets.

4. Track other general mar-ket indicators, including:

• The upside-down vol-ume is a short-termindex that relatestrading volume instocks that close up inprice for the day tovolume in stocks thatclose down.

• The percentage of newmoney flowing intocorporate pensionfunds gives an insightinto institutionalinvestor psychology.

• An index of "defensive"stocks can provideinsight into the mar-ket's direction; whenthese safer stocks startshowing strength, it

may be time to moveinto defensive positions.

The key point to remember is that you should learn tointerpret the daily price andvolume changes of the gener-al market indices, and theaction of the individual market leaders. Once youknow how to do this, you willimprove the performance ofyour investment portfolio.

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10 A U D I O - T E C H

NINETEEN COMMON MISTAKESMOST INVESTORS MAKE

If you follow the ruleswe've presented forputting the CAN SLIM sys-tem to work in your port-folio, you should enjoyexcellent returns.However, even the mostexperienced investorsoften make the sameclassic mistakes thatlimit their profits or causesteep losses. Here arethe 19 mistakes you mustavoid:

1. Stubbornly holding onto losses when theyare very small and rea-sonable. Instead ofgetting out cheaply,many investors holdon until the loss getsso large it costs themdearly. Withoutexception, cut everyloss at 7 to 8 percent.

2. Buying on the waydown in price, therebyensuring miserableresults. A decliningstock seems to be areal bargain. Butremember: With fewexceptions a stock’sprice is high or low forgood reasons.

3. Averaging down in

B U S I N E S S B O O K S U M M A R I E S 11

price rather than upwhen buying. If youbuy a stock at $40 andthen buy more at $30,and average your costat $35, you are follow-ing your losers andputting good moneyafter bad.

4. Buying large amountsof low-priced stocksrather than smalleramounts of higher-priced stocks. Whenyou invest, buy thebest merchandiseavailable, not thecheapest. Low-pricedstocks cost more incommissions and aremore volatile, usuallyto the downside.

5. Wanting to make aquick and easy buck.Wanting too much, toofast, without the prop-er preparation, canlead to big losses.

6. Buying on tips, rumors,split announcements,and other news events,stories, advisory ser-vice recommendations,or opinions you hearfrom supposed marketexperts on TV. Trustwhat you have learnedthrough hard work, notrumors and tips, whichusually aren’t true.

7. Selecting second-ratestocks because of dividends or low price-earnings ratios.Dividends and P/Eratios aren’t as impor-tant as earnings pershare growth. In manycases, the more a com-pany pays in dividends,the weaker it may be.

8. Never getting out of the starting gateproperly due to poorselection criteria.Many people buy high-ly speculative, risky

stocks that have questionable earningsand sales growth;inevitably, they getwhat they deserve.

9. Buying old names youare familiar with.Many of the bestinvestments will benewer companies that,with a little research,you could discover andprofit from before theybecome householdnames.

10. Not being able to rec-ognize and follow goodinformation and advice.Friends and relativescan give bad advice.So can some stockbro-kers and advisory services, becauseevery professionincludes a small minority who are topperformers, many whoare mediocre, andsome who are trulyawful.

11. Being afraid to buystocks that are goinginto new high groundin price. A stock thatreaches a new highmay be on its way tomuch greater highs,as discussed earlier inthis summary.

12. Cashing in small easy-to-take profits, whileholding the losers.You should do theopposite: Cut yourlosses short, and letyour profits grow.

13. Worrying too muchabout taxes and commissions. Themoney to be made byselecting the rightstocks is enormous in comparison to thecost of taxes and commissions.

14. Focusing on what to

buy, and not under-standing when thestock must be sold.Timing your exit is asimportant as planningyour entrance.

15. Failing to understandthe importance of buy-ing quality companieswith good institutionalsponsorship.

16. Speculating too heavily in options and futures becausethey’re thought to be away to get rich quick.

17. Rarely transacting "atthe market" and prefer-ring to put price limitson buy and sell orders.By quibbling on aneighth of a point, theymiss the stock's largerand more importantmovement.

18. Not being able to makeup your mind when adecision needs to bemade. This invariablypoints to lack of aplan.

19. Not looking at stocksobjectively. Relying onyour emotions or onlyon your opinion is arecipe for failure.

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WHEN TO SELL AND CUTYOUR LOSSES

When does a loss becomea loss? Many people feelthat they only incur a losswhen they actually sell ata loss and, thus, hold on— for even greater losses.In actuality, a loss occurswhen the market pricegoes down. If 100 sharesof a stock go from $40 to$28, the owner has only$2800 (instead of $4000)

12 A U D I O - T E C H

of value, whether that is incash or stock.

As mentioned elsewhere,limit your losses to 7 or 8percent. The most impor-tant factor here is: If youuse charts to time yourbuys at correct buy or"pivot" points coming off ofsound chart bases, (priceconsolidation areas), yourstocks will rarely drop 8percent from a correct buypoint. This is a big key forfuture success.

Once you are ahead andhave a good profit, youcan afford to give thestock more than the 7 or 8percent limit. Do not sella stock just because it isoff its peak price. Being 7or 8 percent off the buypoint is a good deal differ-ent. It means that youpicked the wrong stockand/or bought at the wrongtime. You are losing yourmoney. Being off the peakprice means that you haveearned a profit and canafford to give the stock alittle more room. You canabsorb a 10 or 15 percentcorrection. The key is timing your purchasesexactly at breakout pointsin order to minimize the chance of your stockdropping 8 percent.

What if a stock gets awayfrom you and loses 10 per-cent? Cut your lossesimmediately. Similarly,"buying on the dips" is anamateur’ strategy thatalmost always leads tolosses. And never investon margin unless you’rewilling to cut all of yourlosses short. Small lossesare like cheap insurance.Take your losses quicklyand your profits slowly.

In a related vein: Neveraverage down in price. Itis one of the most unwisethings an investor can do.

A stock’s price (down orup) is only important tothe condition of the stockin the present. Thus, buy-ing more of a stock whoseprice is falling is a surerecipe for disaster.Similarly, don’t be tooquick to take profits.

For longer-term investing,here is another method touse: At the end of eachquarter, compute the percentage increase ordecrease in price sincethe previous quarter andlist them in order of theirrelative performance.After a few reviews, thewinners and losers willbecome apparent. Thendetermine potential profitand possible loss. Identifythese criteria and stick tothem; e.g., 8 percent forlosses and 125 percent forgains. However, don’t fallinto the trap of being thelong-term investor whoholds onto a stock no mat-ter what happens. Cutyour losses.

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discipline not to pyra-mid (buy more at ahigher price) or add toyour position more than5 percent past thatpoint. Then sell eachstock when it is up 20percent. And, of theother corollary: Cut alllosses at 8 percent offthe buying price.

There are several advan-tages to this plan, but theprimary one is that it putsmoney to its most effi-cient use. The weakerperformers feed the betterperformers.

Many market-leadingstocks go through "climaxtop," which are rapidaccelerations after anadvance of many months.Here are the signals:

1. Largest daily price run-up.

2. Heaviest daily volume.

3. Exhaustion gap: Arapidly advancingstock is greatlyextended from its baseand then opens up anew day higher yet.

4. Climax top activity: Astock’s advance getsso active that it has arapid price run-up fortwo or three weeks ata spread greater thanany previous weekprior to the originalmove.

5. Signs of distribution(selling).

6. Stock splits.

7. Increase in consecu-tive down days.

8. Upper channel line.

9. 200-day moving average line.

WHEN TO SELL AND TAKEYOUR PROFIT

If you don’t sell early,you’ll be late. The secretis getting off the elevatorwhile it is still on its wayup and avoiding the rideback down. And the keyto doing so is having aprofit and loss plan.O’Neil describes a basicbuy/sell rule:

Since successfulstocks tend to move up20 to 25 percent, thendecline, build newbases and, in somecases, resume theiradvances, buy eachstock at the exact pivotbuy point and have the

B U S I N E S S B O O K S U M M A R I E S

10. Selling on the waydown from the top.

Low volume and otherweak action:

1. New highs on low volume.

2. Close at/near day’s low.

3. Third/fourth stagebases: The third newbase becomes obviousto everyone in the mar-ket. Sell when yourstock makes a newhigh off a third- orfourth-stage base (i.e.,its third or fourth newbase).

4. Signs of a poor rally:an unsustainable rallywill have a lot of selling near the top.

5. Decline from the peak.

6. Poor relative strength.

7. Lone Ranger: Only oneimportant member inan industry group hasprice strength.

Breaking Support:

1. Long-term upwardtrend line is broken.

2. Greatest one-day pricedrop.

3. Falling price/heavyweekly volume.

4. 200-day moving aver-age line turns down.

5. Living below 10-weekmoving average.

Other Pointers:

1. If you cut all losses at7 or 8 percent, take afew profits when up 25or 30 percent.

2. Consider selling if astock runs up and then

good news or majorpublicity is released.

3. When it’s obvious toeveryone that a stockis going higher, sell,because it is too late.

4. Sell when quarterlyearnings percentageincreases slow materially for two consecutive quarters.

5. Be careful of selling onbad news or rumors.

6. Learn from your pastmistakes.

Sometimes it is importantto be patient and hold astock. Specifically, buygrowth stocks whosepotential price target canbe projected accurately.Also, with every new pur-chase, draw a red line — adefensive sell line — on achart at 8 percent belowthe buying price. On theother extreme, neverallow a stock that rises 20percent to fall into theloss column. Also, allowmajor advances to takeshape. Don’t take profitsduring the first eightweeks of a move unlessthe stock is in trouble.

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OTHER IMPORTANT QUESTIONS:SHOULD YOU DIVERSIFY,INVEST FOR THE LONG HAUL,SELL SHORT, ETC.?

Many investors overdiver-sify. The best results areachieved through concen-tration, by putting youreggs in a few baskets thatyou know very well. Thedesire to hedge risk byspreading it out over manystocks is understandable,but it also means that you

have that many morestocks to keep track ofand industries to becomeknowledgeable about.Broad diversification isoften a hedge for igno-rance. Diversificationitself is sound as long asyou don’t overdo it anddiversify with a plan.

How about timing of purchases? Using a fol-low-up purchase plan willhelp you keep more ofyour money in a few of thebest stocks. With such aplan you make small addi-tional purchases of astock that has advanced 2 or 3 percent past youroriginal purchase or mostrecent price. Of course,don’t chase a stock past acorrect buy point. This isbetter than haphazarddiversification; this focus-es the diversification onquality and profitability.

Should you invest for thelong haul? Actually, theholding period isn’t theissue. Profitability is theissue, and you achieve itby buying the right stockat precisely the righttime. Conversely, a well-run portfolio should nothave a loss carried on formany months, so length ofownership is driven byprofitability.

Should you day trade?You are dealing with fluc-tuations that are harder toread than basic trendsover a longer period oftime. If done with realskill, some forms of daytrading can work for somepeople, but they require alot of skill.

Should you use margin?In the first year or twowhile you’re still learning,it’s most prudent to oper-ate on a cash basis. Aftera few years of experience,a sound plan, and a good

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14 A U D I O - T E C H

set of buy and sell rules,you might consider buyingon margin. Remember:this means you are bor-rowing money from yourbroker. A fully marginedaccount means that 50percent of the money hasbeen borrowed. Mostimportant, cut lossesshort without exception.

Never answer a margincall. If a stock in youraccount collapses in valueto where your broker asksyou to put up money orsell stock, sell stock. Themarket is telling you thatyou made a wrong choice.Putting more money afterit will just make it worse.

What about short selling?Short selling is the reverseof the normal buying pat-tern. You sell the stock(instead of buy it) eventhough you don’t own itand must borrow it fromyour broker — in the hopethat it will go down inprice, at which point youcan "cover your position"by buying the stock at alower price and pocketingthe difference. If youengage in this approach,don’t do it in a bull market.The most effective time todo this is at the beginningof a general marketdecline, which means youmust be reading the chartto track overall perfor-mance. Two typical chartpatterns are the head andshoulders pattern and thecup with handle in a thirdor fourth stage.

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HOW TO READ CHARTS LIKEAN EXPERT AND IMPROVE YOURSTOCK PICKS AND TIMING

Charts are your invest-ment road map. They tellyou where your stocks areat all times. Chart pat-terns (or bases) are simplyareas of price correctionand consolidation.

Important questions to beable to answer from thecharts are:

• Are price and volumemovements normal orabnormal?

• Do movements signalstrength or weakness?

• Is a stock in the properposition for a buy or,even though an other-wise "good" company,is it extended too far?

In the stock market, histo-ry repeats itself. Beaware of precedents.

The most common pattern,the "cup with handle,"looks like a side view of acup. Cup patterns canlast from 7 to 65 weeks,but most run three to sixmonths. The usual correc-tion from the absolutepeak (top) of the cup tothe low (bottom) pointranges from 12 percent to33 percent. A strong pricepattern should have aclear and definite trendupward prior to the begin-ning of the base pattern.In most cases the bottomshould look like a "U"rather than a "V." Thispart of the pattern is aneeded natural correction.

The formation of the han-dle area generally takesone or two weeks and hasa downward price drift orshakeout, where the pricedrops below a prior lowpoint in the handle. This

happens near the end ofits down-drifting move-ment. Volume will dry upnoticeably near the lowsin the handle’s price pull-back phase. When han-dles do form, they mustoccur in the upper half ofthe base structure of thecup, and the handle shouldbe above the stock’s 200-day moving average.

Constructive patternshave tight price areas —small price variation fromhigh to low for the week.If the stock has a wideprice pattern every week,it will have been in themarket’s eye and will failwhen it attempts to breakout. When a stock forms aproper cup-with-handlepattern and then chargesthrough an upside pricepoint — the pivot point orline of least resistance —the day’s volume shouldincrease at least 50 per-cent above normal. Mostof the increases are gener-ated by professionalsbecause it tends to appearrisky to the general publicto buy a stock just as ithas hit a new high. Thewinning individual investorwaits to buy at theseexact pivot points.

Nearly all proper bases willshow a dramatic dry-up involume for one or twoweeks along the very lowof the base pattern and inthe low area of the handle.The combination of tight-ness in prices and dried-upvolume is generally quiteconstructive.

Another valuable clue isthe occurrence of bigspikes in daily and weeklyvolumes. Volume is thebest measurement of supply and demand andinstitutional sponsorship.The fact that a stock has closed up on heavyvolume for several weeks

It isn't enough to understanda method for selecting

winning stocks. To improveyour performance in the stockmarket — to make a bigimprovement — you need toapply all of what you'velearned. Remember the simple acronym CAN SLIM.Each letter stands for one ofthe seven basic fundamentalsof selecting outstandingstocks.

Most successful stocks sharethese seven common charac-teristics at emerging growth

stages, so they are worth com-mitting to memory. Repeatthis formula until you canrecall and use it easily:

• C equals CurrentQuarterly Earnings perShare: They must be upat least 18 or 20 percent.The higher, the better.Also, quarterly salesmust be accelerating orup 25 percent.

• A equals AnnualEarnings Increases:Require significantgrowth for each of thelast three years and areturn on equity of 17percent or more.

• N equals New Products,New Management, NewHighs: Look for newproducts or services, anew senior managementteam, or significantchanges in industry con-ditions. Buy stocks asthey begin to make newhighs in price.

• S equals Supply andDemand: It doesn't mat-ter whether a companyhas a large capitalizationor a small cap, as long asit fits all of the otherCAN SLIM rules. Lookfor big volume increases.

• L equals Leader orLaggard: Buy marketleaders and avoid lag-gards. Buy the No. 1company in its field.Most leaders' RelativePrice Strength Ratingwill be 80 or 90 or higher.

• I equals InstitutionalSponsorship: Buy stocks

B U S I N E S S B O O K S U M M A R I E S

in a row is a healthy sign.

There is an upside to mar-ket corrections. Eightypercent of the time, pricepatterns are created dur-ing periods of corrections,so you shouldn’t give upon intermediate-term sell-offs or bear markets. Bearmarkets can be as shortas 3 to 6 months or, morerare, as long as two years.Bear markets create newbases on new stocks thatcould be the next cycle’swinners.

Other patterns to look forinclude:

• Saucer with handle:Similar to the cup withhandle, in this patternthe saucer part tendsto stretch out over alonger period of time.

• Double-bottom pricepattern: This lookslike the letter "W."They may also havehandles. In theory, thisis not as powerful apattern, since thestock falls back twice.The pivot point is onthe top right side ofthe "W" and should beequal to the tip of themiddle part of the "W."

• A high, tight flag: Thispattern, which consistsof an advance of 100percent to 120 percentin a very short periodof time and is followedby a sideways correc-tion of no more than 10percent to 20 percent,is very rare. It appearsno more than once ortwice in a bull market.This strongest of pat-terns is very difficult tointerpret correctly.

• A base on top of abase: During the later stages of a bearmarket, a seemingly

negative conditionflags what may beaggressive new leader-ship in a new bullcycle. A powerfulstock breaks out of itsbase and advances butis unable to sustain anormal advance of 20percent to 30 percentand is pulled back bythe rest of the generalmarket.

• Ascending bases, likeflat bases, occur mid-way along a move upafter a stock has bro-ken out of a cup withhandle. It pulls back10 to 20 percent aftereach advance, witheach new base fromthe resulting pullbackbeing higher than theprevious one.

• Wide and loose pricestructures: These usu-ally fail, but they cantighten up later.Nothing dramatic hap-pens, though somebuyers are lured intothinking a majoradvance is imminent.

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15

with increasing institu-tional ownership and at least a few sponsorswith top-notch recentperformance records.

• M equals MarketDirection: Learn todetermine overall market

direction by accuratelyinterpreting daily marketindices' price and volumemovements, and theaction of individual mar-ket leaders. This candetermine whether youwill win or lose.

By using this simple, proven,and extremely powerfulmethod, you can makemoney in stocks in any typeof economy.

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ABOUT THE AUTHOR

William J. O’Neil started in the stock market with a small $300 investment that launched what today is con-sidered the premier source of investment research and education to individual investors and professional moneymanagers.

He started William O’Neil + Co., Incorporated and became one of the youngest ever to buy a seat on the NYSE.In 1963 his company developed the first computerized database on the securities market. Today, over 600 ofthe most influential institutional money managers use William O’Neil research services. And the database,established almost 40 years ago, has grown to become the most comprehensive equity database in existencetoday, tracking over 200 data items for over 10,000 companies

In 1984 Mr. O’Neil launched Investor’s Business Daily®, a national daily newspaper. Today, with nearly a million daily readers it is considered one of the most useful investment research tools available.

How to Make Money in Stocks summarized by arrangement with The McGraw-Hill Companies, Inc., fromHow to Make Money in Stocks: A Winning System in Good Times or Bad, Third Edition, by William J.O’Neil. Copyright © 2002 by William J. O’Neil. Copyright © 1995, 1991, 1988 by McGraw-Hill, Inc.

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