Money can be made in stock market by purchasing stocks at a price that is lower than your selling price. However, wealth is created only when one does this on a consistent basis.
To generate profits on a consistent basis, you need to have an investment process that answers three crucial questions:
1. Which stock to buy
2. When to buy
3. When to sell
I will briefly discuss about the investment process that I use:
Which stock to buy?
There are over 5,000 stocks listed in the Indian market and selecting which stock to buy can be an extensive process. This holds true when one does not have an investment criteria.
So, you need to have few investment criteria that help you in screening best quality stocks that have the potential to deliver solid returns in future.
Finding quality stocks
The best companies are ones that post strong sales and earnings growth quarter after quarter and year after year, driven by a wonderful product or service.
So, the first step is to filter companies in terms of sales and earnings growth in most recent quarters as well as on annual basis. Look for companies that have been growing earnings at 20-25% or more ( higher the better).
Also, make sure we are looking at companies that make efficient use of their capital. Therefore, you should use return ratios as part of your screening process. I generally look at companies with return on equity of over 15%.
Also, pay attention to companies that could benefit from something new such as a new product or service, new management, new industry trend/regulation. Keep an eye on stocks that are making new highs or are quite near to their all-time highs.
The above criteria will fetch you only quality companies and remove all those stocks that do not deserve your attention. A retail investor hardly has the time and resources to look at a big universe of stocks and hence the above criteria will help you to keep your focus on only the quality names.
When to buy?
Once you have a watch list of high growth stocks ready, I would encourage you to use charts. Why? Charts serve as an important risk management tool and if studied properly, charts can help you to take informed trading decisions.
Have you ever seen a chart of a multi-bagger? Have a look at Eicher Motors’ weekly chart. One can see that while earnings have grown in a linear line, the stock price has witnessed periods of consolidation and periods of huge price gains. This can be attributed to the greed and fear of market participants resulting in price volatility.
Stocks tend to make familiar consolidation patterns every now and then, mainly due to the psychology behind trading decisions of other market participants. With effective use of chart patterns, you will be able to get into a stock at a time when the probability of a huge price move is high.
Moreover, you need to take into account how the overall market is doing. There is no point investing into a stock when the market is in a downtrend since three out of four stocks follow the general market. The best time to get into a stock is when the market reverses trend and enters into a Confirmed Uptrend.
When to sell?
Just like buying, one should make use of charts to take selling decisions. Get out of stocks when they are showing signs of weakness such as breaching key support lines (50-day and 200-day moving averages) on huge volumes. There could be something wrong with the company which we small investors might not be aware of and hence it becomes very important to sell based on weakening technicals.
Also, have a stop-loss rule in place as per your risk appetite. I use a stop-loss in the range of 8-10% for all my trades. Even after breaking out of a proper chart pattern the stock might witness some profit booking and remain sideways for a long period. Investors can come out of such stocks and deploy their capital to better opportunities.
Key Takeaways and Learning Sources
The above strategy is known as CAN SLIM and was developed by legendary investor, William O’Neil. Early on in his investing career, O’Neil looked at 1000s of historical multi-baggers and found seven common factors exhibited by all big winners. CAN SLIM is an acronym for each of those seven factors.
Accelerating earnings and sales growth, high return on equity, new products/services, leading company in a top industry group, rising institutional ownership, stock breaking above prior resistance levels with rising demand and favourable market condition were the common factors depicted by stocks that went on to become multi-baggers.
For budding investors who are interested in learning the CAN SLIM investment method, I encourage you to opt for an online seminar on CAN SLIM or read How to Make Money in Stocks by William O’Neil. Reading the book will require good amount of time and effort on your part and hence a 5-hour seminar might make sense for the busy folks.
Investors can also make use of MarketSmith India, an investment tool that helps users to find profitable investment ideas based on CAN SLIM method.
I hope you found the answer useful.
Happy Investing!
