The Growth Stocks Best Placed For A Rebound (And How To Find Them)

The Growth Stocks Best Placed For A Rebound (And How To Find Them)
Stéphane Renevier, CFA

over 1 year ago5 mins

  • Seven characteristics support the best growth stocks: strong current profit growth, strong annual profit growth, something new about them, supportive supply and demand, a leading industry, strong institutional support, and a market in an uptrend.

  • William O’Neil’s growth investment strategy calls for buying stocks when they’re breaking out of a cup-and-handle formation, and putting a stop-loss 8% below your entry price.

  • And the most appealing stocks based on these criteria right now are in the energy and healthcare sectors.

Seven characteristics support the best growth stocks: strong current profit growth, strong annual profit growth, something new about them, supportive supply and demand, a leading industry, strong institutional support, and a market in an uptrend.

William O’Neil’s growth investment strategy calls for buying stocks when they’re breaking out of a cup-and-handle formation, and putting a stop-loss 8% below your entry price.

And the most appealing stocks based on these criteria right now are in the energy and healthcare sectors.

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Investors’ once-beloved growth stocks have fallen by the wayside lately, and they’re now trading at a serious discount to their own history. That suggests now might be the precise time to roll out the “CAN SLIM” method: an investing approach that picks out the seven shared characteristics of those that have gone on to make big gains in the past. Let’s take a look at those seven traits, and, more importantly, which growth stocks are showing them now.

What are the seven characteristics?

Current quarterly earnings: Look for stocks that have increased their profits by at least 25% in the most recent quarter. While generally the stronger those profits are, the better, the quality of profit growth is important too. So pick out companies that have also grown their sales by at least 20% and that have a return on equity (ROE) of at least 17%.

Annual earnings growth: Go for stocks that have grown their profits by at least 25% in each of the past three years. Looking beyond the most recent quarter is important if you want to avoid investing in companies that have only managed to temporarily boost their profits.

New product, management, or price high: Stocks tend to achieve their largest price gains after a game-changing product is launched – Apple’s iPhone, say – or when something new happens. So keep an eye out for potential catalysts of growth and profitability: does the company have a new management team? Is it launching a new product? Is it entering a new market? Is its stock price reaching new highs?

Supply and demand: When a company’s stock price is rising with above-average volume, it could indicate that big institutional investors are buying up its shares. That’s a good sign, as they tend to do their due diligence and they’re generally in it for the long haul.

Leader or laggard: The stocks showing the most explosive price growth tend to be leading stocks in leading industry groups. Unlike value investors who buy badly performing stocks in declining industries, CAN SLIM investors usually buy the best stocks in the best industries. For them, growth potential and interest from other major players is more important than valuations.

Institutional ownership: The best stocks will tend to have strong and growing support from institutional investors. So look at the number and quality of funds invested in the company, and how much they own. And screen out stocks that have a daily trading volume of fewer than 400,000 shares: their price might be too sensitive when large investors sell their stocks.

Market direction: Even the best stocks rely on a bullish market to really perform, so it’s important that you buy only when the overall market is in a positive trend. When the market is pointed downward or in a correction, it’s generally best to wait on the sidelines until you’ve got confirmation that the uptrend is back.

Anything else?

William J. O'Neil, the former stock broker and entrepreneur who invented the CAN SLIM method, says it’s not enough just to watch for those attributes. He also recommends specific buy and sell rules. He says the best moment to buy is when the stock is breaking out of a “cup-and-handle” formation, like the one below – when it has spent time consolidating after previous gains, and is ready for the next move.

Cup-and-handle chart pattern. Source: Wiliam J. O'Neil
Cup-and-handle chart pattern. Source: Wiliam J. O'Neil

As for when to sell, O’Neil says you should always cut your losses if the price drops 8% below your entry level. When you’re investing in risky, high-growth stocks, making sure to preserve your capital by cutting your losses is as important as identifying the fastest-growing companies.

What are the pros and cons of the strategy?

The strategy is more than just an investment philosophy: it proposes some specific rules to identify which stocks you should invest in, as well as when to buy and sell.

As we’ve highlighted here before, having a defined investment process can help you learn from your mistakes and will reduce the likelihood that you’ll make decisions based on emotion, rather than strategy. And by following the CAN SLIM rules, you’re likely to pick the next big winner, as almost all of the fastest-growing stocks do display these characteristics.

However, the downside is that not all the rules are clearly defined. For example, O’Neil doesn’t specify what constitutes a down market, how many stocks you should hold in your portfolio, or how much you should invest in each position. Plus, following O’Neil’s rules would lead to a high turnover – and hence transaction costs – and require active management of your portfolio.

Lastly, investing in the fastest-growing companies works well in the up-trend market we’ve seen over the past decade, but it doesn’t work as well in range-bound or bear markets. That makes them a particularly risky bet given that this is exactly where we find ourselves now.

So what’s the opportunity here?

The stocks that currently rank highest according to the seven characteristics are concentrated in two industries.

Energy companies like Earthstone Energy (ticker: ESTE), Matador Resources (MTDR), New Fortress Energy (NFE), and Pioneer Natural Resource (PXD) all score highly. And on the healthcare front, companies like Vertex Pharmaceuticals (VRTX), Eli Lilly (LLY), and Regeneron Pharmaceuticals (REGN) are leading the pack.

There are a few good picks in other industries, mind you: car dealership Autonation (AN), waste recycler Darling Ingredients (DAR), and electrical wire manufacturer Encore Wire (WIRE) likewise hit all the characteristics. Take a look at all these companies in greater depth, or try to apply the CAN SLIM method to other growth stocks, and you might just find something that takes your fancy.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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