TMF Interview


TMF Interview: Bill O'Neil

June 20, 2002 (Part 1) & June 25, 2002 (Part 2)

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 was 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 (makes us wonder what we've been doing with our time!) and his investment research company William O'Neil & Co.Inc. counts among its clients hundreds of the top institutional investment firms worldwide.

The Motley Fool's Senior Editor for Investing Bill Mann (TMF Otter) recently spent some time with O'Neil ahead of the release of the third edition of his national bestseller How to Make Money in Stocks. Today we offer the first part of our interview, to be concluded next week.


TMF Otter: Many people have learned for the first time what a real bear market feels like. The last prolonged pain in the stock market came more than two decades ago, when far fewer people were active in the stock market. What are some of your key observations on investing today?

O'Neil:  The stock market is human nature on parade. Intelligent, highly educated human beings can easily get into trouble and lose money because the stock market nearly always moves directly opposite to the psychology of the typical investor. For example: We are a nation of bargain seekers. We want to buy something that seems cheap because it's on sale. So, people buy a stock on the way down at 50 because it was 80 and looks like a real deal. This is a deadly sin in the market and one of the worst habits an investor can have. Why try to catch a falling dagger? Stocks that decline more than normal are under heavy liquidation by institutional investors and are almost always down for a reason -- i.e., the tide has turned for the company and something is starting to go wrong.

TMF Otter: It's funny, because it seems that there is no middle ground for the typical investor. He can either get excited about some company because the stock is going up, he can be terrified because it is dropping, or he can get greedy because it looks like a bargain since it has dropped so much. How do you suggest investors learn to improve their success rate in stock selection?

O'Neil:  Anyone can learn to invest more intelligently and much more profitably, but you must begin by reading and studying the few right books on the market and becoming brutally realistic about all common stocks. First, you must recognize that you are simply not going to be right all of the time. Big league baseball players are outstanding if they hit three times out of ten. Three-point basketball shooters are good if they score on four of ten shots. An all-pro passer in football may be great if he hits six and misses four. In a lifetime of investing, you'll probably only be right five or six times out of ten. So you absolutely must have a rule to always protect yourself. When you start off wrong, you are exposing yourself to a loss that can at least half of the time get larger and larger until it does serious damage to your portfolio.

TMF Otter: You've stated publicly that an investor who followed your system would have avoided the egregious losses suffered by holders of Enron or Global Crossing. How would an investor be protected in your mind without also taking the chance of selling out on good companies way too soon?

O'Neil: My rule is simple -- any stock that I buy that declines 7% or 8% below my actual purchase price, I will always without exception, sell to cut short my loss.

TMF Otter: No exceptions?

O'Neil: None. This way I guarantee myself that my capital will never be exposed to a 25%, 50%, or 75%, loss which is always difficult to recover from. So, your first loss is always your smallest loss. The only insurance policy you can take out to protect against a large devastating loss is to cut them all without exception while they're still small.

TMF Otter: No averaging down? No buying back a stock that you are convinced is undervalued?

O'Neil: I will never average down in price. If I bought at $50, I will never buy more at $45 or $40 -- that's risking more money in a stock that's already wrong and not working -- so why put more good money after bad?

I prefer to average up on each stock that is working. At least, when you're right and the stock proves it by going up in price, you'll have more money in the one you're right on and less in the stock where you're wrong. So, you see, the real key to stock market success is not to be right all the time (which you can't be) but to have more of your money in the stocks you're right on and lose less percentage wise and have fewer dollars in the stocks where you're wrong. A few really big profits and several smaller losses is your objective.

TMF Otter: With over 10,000 stocks to choose from, how many stocks should you own?

O'Neil: Before you begin to invest, decide how many stocks you will own.

TMF Otter: Easier said than done, right? Every investment guru alive tells us that we need to be diversified. Plus, it's easy to get excited about the next "new opportunity."

O'Neil: If you have $15,000 to invest, limit yourself to three stocks bought one at a time. Don't buy them all at once. If you have $50,000, limit yourself to four stocks; $100,000, five stocks; and if $1 million, six or seven. You don't need to over-diversify or over asset allocate. Money is made by putting your eggs slowly and intelligently into fewer baskets you know well and watching those very carefully. Over-diversification is a hedge for ignorance.

TMF Otter: That's a fairly contrary opinion. How do you ensure that the companies you hold are good ones? It seems like your margin for error is much smaller.

O'Neil:  For more than 40 years of investing, I never bought stocks based on tips, thoughts, rumors from friends, brokerage firms, or analyst reports, technical analyst recommendations, or assumed experts pushing their favorite picks on market TV programs. That's a fast way to lose money.

TMF Otter: Obviously, then the key for you is stock selection. But in How to Make Money in Stocks you are very clear about the need both for a defined buying strategy and a defined sell strategy. What are your definitions based upon?

O'Neil: Rather than listening to Wall Street's conventional wisdom and strong egos, we analyzed all of the best-performing stocks each year for the past 50 years. We evaluated all the known fundamental and technical variables each super winner showed before they soared 100% to 1000% or more. Plus, we studied how these variables changed when these great winners finally topped and began their substantial price declines.

Our buy and sell rules were not based on our personal beliefs, systems, philosophy or opinions, but precisely on how the stock market actually worked for the last half century.

TMF Otter: What you're talking about are home runs. Most investors would suggest that the current market is one that favors singles, or maybe even errors and strikeouts.

O'Neil: That's the key point of the "M" in our CAN SLIM™ methodology. You have to respect what the market is telling you.... If it's down, we don't try to fight against that trend by buying stocks. I wait until you see a confirmed uptrend and know it's safe to buy.


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.