This is not a book advising you on what to invest in; rather it is advice on what to avoid. Or rather, who to avoid. Never forget that brokers, fund managers and the like are salesman, first and foremost and often last. They want your business because that is how they make their money. According to the author, who was one for many years, they spend so much time honing their sales skills that they typically are no better at picking stocks than their clients.
Some specific tips:
- Go ETF, not mutual funds
- For foreign indices go with equal weight indices rather than market cap weight (since typically one or two large companies dominate)
- “Buy and hold” and the futility of timing the markets “is one of the greatest stories ever told, despite the fact that in the past century we’ve seen 25 cyclical bear markets and two bone-crushing secular bear markets.” Investment professions market and promote stories which serve their interests, so always think about what they are trying to convince you to do, and why.
- Avoid like the plague: SPACs (companies which set up an all-star management team first, they find a struggling company to buyout and “turn around”), reverse Chinese mergers (similar; but involves a Chinese company with majorly cooked books buying a small, yet stock market listed, company in order to get themselves listed after the merger), “one-drug biotechs” (there are only ~7 biotech-developed drugs approved by the FDA each year)
- If you must get investment advice, hire an RIA (Registered Investment Advisor), who are fee-based rather than commission-based, and have a higher fiduciary responsibility to their clients: “I work with smart people who are more concerned with what’s right rather than ‘What can I sell?'”
William O’Neil is the famous founder of Investor’s Business Daily (ironically now printed only weekly) and seems to deserve his reputation as a pro stock picker. He shares his secrets in this book (along with plenty of plugging for IBD products…). He outright refutes the concept of a “random walk” (throwing darts directly at Malkiel?), claiming it is definitely possible to beat the market.
CAN SLIM is O’Neil’s stock picking system (it’s not a weight loss system as the name may imply):
- C – Current earnings per share >20% higher than same quarter one year ago. Also check that sales are increasing over the last three quarters.
- A – Annual earnings per share growth of 25 – 50% over past 3 years. Also look for high ROE.
- N – positive News. Don’t be afraid to buy a stock making new highs. Don’t worry about P/E ratio at all. Focus on newer companies (<10 years since IPO).
- S – prefer companies with smaller number of outstanding Shares – easier to budge price.
- L – (Leaders vs. Laggards) DON’T buy stock which has retreated to the point it looks like a bargain – too much risk it will keep falling. Buy when going up and hope it keeps going higher. Look for breakout after 7-8 weeks of stable base. Look for high, increasing relative strength. Average up if you must (when your pick is up a few %) but never average down.
- I – look for increasing Institutional sponsorship, especially from high performing mutual funds.
- M – sign of Market top: “distribution day” (distribution as in “selling”) – major indices flat or down on increased volume from previous day, occurring on 4-5 days in 4-5 week period. When a bear market is detected, get into cash fast. Then wait for the signs of a bull market before jumping back in: look for an up day, followed within 4-7 days by a “follow-through” day of very large gains (~2%) on heavier volume than the preceding day.
After all that…O’Neil admits that only 10 – 20% of his picks have ever turned out to be real winners. So, the savvy investor must be aggressive about limiting losses. Always cut and run if stock goes down 7-8%. Think of it like insurance. A variant that yields same results but is maybe easier to swallow: sell half at -5%, other half at -10%. Given that expected gains on remaining winners are 20-25% you’ll still come out ahead if you can pick winners only 1/3 of the time. If you must invest during a bear market (not recommended), lower your acceptable loss to 3% and profit taking to 15%.
Other sell signs (some confusing and contradictory – maybe why the aforementioned 20% rule exists):
- largest daily gain or loss occurring after many days of solid gains
- heavy volume with no price change or loss
- rapid price run-up for 7-8 days out of 10
- 4-5 down days for every 2-3 up days (whereas it had been the reverse)
- new high on lower volume
- close at day’s low for several days
- 8% decline from peak
- major publicity with good news
- overabundance of optimism
- deceleration in quarterly earnings increases for two quarters in a row
Don’t buy stocks <$15. O’Neil recommends holding no more than 5 stocks, since timing is important and monitoring multiple holdings may cause you to miss something important. Don’ be afraid to use margin once you are comfortable with the system and are seeing success.
Biggest mistakes: stubbornly holding on to losses for too long, buying on the way down, and not sticking to rules!
Research winning companies/industries to find opportunities in supplier companies – eg. Monogram, maker of chemical toilets for Boeing during airline boom.
There’s a lot of technical analysis charting discussed in the book, primarily focused on the perfect buy point. I didn’t spend too much time squinting at the charts – seems like there are plenty of points on the charts which meet the cup-and-handle or stable base criteria but did NOT turn out to be a perfect buy point. Anyway, cup-and-handle with large volume increase on the handle seems to be the recommended buy point. Basically looking for a point where price and volume steadily drops for a time, then slowly picks back up until a large volume, large increase day. (Only buy solid CAN SLIM companies – not just anything which meets the technical pattern!)
I plan to test out a few things from this book on Quantopian, particularly the market direction signals. Even if you could just time the market and jump into and out of index funds at the appropriate time you would end up miles ahead.
Here’s the secret to making money in the stock market: buy low-cost index funds which cover the whole market. There, not so hard, right? Burton Malkiel has been espousing this for 40 years, when the first edition of this book was published and index funds didn’t even exist yet. The data, as he presents in the book, shows him out well. Sure, some years some active fund managers score big, but they are no more likely than any other manager to outperform the market the following year(s). The only consistent winner is a properly-weighted portfolio of index funds.
That said, Malkiel gives lots of bits of advice on manual methods of picking stocks. After all, if you see a $100 bill on the street, don’t be like the finance professor who said “it must not be real; otherwise someone would have already picked it up.” Really you should respond “I must pick it up quickly, otherwise someone else will come and pick it up very soon.” There still are market inefficiencies to be exploited … it is just very hard to do so consistently. Keep your core in index funds, but keep a small pool of funds ready to pick up the $100 bills when you find them…
As far as stock picking goes, Malkiel sees all technical indicators as junk. Well, besides maybe some short term value to a relative strength strategy. But…if any indicator really did work well, the discoverer is surely not telling anyone about it. Too many people doing the same thing would change the market dynamics such that the indicator no longer works.
Fundamental analysis doesn’t bear much fruit either. And we must avoid bubbles, even though they are hard to spot. Here’s a tip: be very wary of buying into something touted as “the future” if it isn’t making solid profits now.
Malkiel does give a “secret formula” for picking stocks late in the book: Long-run equity return = Initial dividend yield + growth rate (of earnings and dividends combined). The trick is knowing what the expected growth rate will be. The typical stand-in here is the P/E ratio — if it is high, then this (might) signify the expectation of growth. But then again, value investors like to buy low P/E stocks…
There is a pretty strong correlation of overall market P/E ratio to forthcoming returns. The lower the P/E ratio of the market, the higher the returns. Based on historical data, a market P/E ratio of < 10.6 has yielded on average 16.4% returns over the next decade while a P/E ratio of > 25.1 yields on average 3.7% returns over the next decade. The returns vs. P/E curve is generally linear between these two points. (Malkiel’s chart on pg. 347) As of this writing, current market P/E is 24.89…we are unfortunately in for a decade or so of single digit returns. (Note: MMM has this point covered as well.)
There are a couple of strategies that Malkiel mentions may have some potential to beating the market. Maybe. (He’s is oh so careful about admitting that anything could ever beat the market long-term!)
1) Value wins. Tilt towards low price-earnings ratios. VVIAX
2) Tilt towards smaller cap companies – they have more room to grow. (IWM – Russell 2000; or IWN, DFSVX – combo of 1 & 2)
3) Momentum and reversion to the mean (AMOMX)
4) Low volatility bought on margin (SPLV)
There’s a chart on almost the final page of the book which kind of blew me away. The 2000’s decade is called the “lost decade” because overall market returns ended up pretty much where they started. But … a diversified portfolio of 5 different funds (using the “age 55” mix), rather than just total market, was up ~100%.
(Note: Malkiel gives the exact same weights for International and Emerging Markets, so on this plot they are right on top of each other.)
In an individual stock portfolio, diversification is also very important in lowering risk. The beneficial effect seems to diminish after about 50 stocks or so. Should also make sure to get about 20% exposure to international stocks.