Is the growth stock market ready for a rebound?

Investing in growth stocks has fallen by the wayside lately, and is now trading at a deep discount to its own history. That suggests that now might be the right time to implement the method."CAN SLIM«: an investment approach that selects the seven shared characteristics of those that have generated great returns in the past. Let's look at the seven traits and, more importantly, which growth stocks display them now.

What are the seven characteristics?​

1. Current quarterly earnings​

We are looking to make an investment in stocks that have grown earnings by at least 25% in the most recent quarter. In general, the stronger those gains the better. The quality of earnings growth is also important. Therefore, we should choose companies that have also increased their sales by at least 20% and have a return on equity (ROE) of at least 17%.

2. Annual profit growth​​

We should filter our investment into stocks that have grown their earnings by at least 25% in each of the last three years. Looking beyond the most recent quarter is important if we want to avoid investing in companies that have only temporarily managed to increase their earnings.

3. New product = high price ​

Investing in growth stocks tends to generate its biggest gains after the launch of an innovative product, for example, Apple's iPhone. So we have to be attentive to possible catalysts for growth and profitability:

• Does the company have a new management team?
• Are you launching a new product?
• Are you entering a new market?
• Is its stock price reaching new highs?

4. Supply and demand​

When a company's stock price rises on above-average volume, it could tell us that large institutional investors are buying its shares. That is a good sign, since they tend to have a positive influence and generally do so in the long term. The most recent example can be seen with Twitter shares when Elon Musk acquired 9% of the shares.

5. Leader or laggard 磊​

Investing in stocks that show the most explosive price growth tend to be the leading stocks in their industry groups. Unlike the value investors While they buy underperforming stocks in declining industries, CAN SLIM investors tend to buy the best stocks in the best industries. For them, growth potential and interest from other major players is more important than valuations.

6. Institutional ownership ️​

The best stocks will tend to have strong and growing support from institutional investors. So we look at the quantity and quality of funds invested in the company and how much they have. We rule out investing in stocks that have a daily trading volume of less than 400.000 shares: their price may be too sensitive when large investors sell their shares.

7. Market direction 

Even the best stocks rely on a bull market for real returns, so it's important that you buy only when the overall market is trending positively. When the market is headed lower or in a correction, it is generally best to wait on the sidelines until you have confirmation that the uptrend has returned.

William J. O'Neil, a former stockbroker and entrepreneur who invented the CAN SLIM method, says it's not enough to just look at those attributes. He also recommends specific buying and selling rules. He says the best time to buy is when the stock is coming out of a "copa and handle«, like the one below, when it has spent time consolidating after previous gains and is ready for the next move.

To decide when to sell, O'Neil says we should always cut our losses if the price falls 8% below our entry point. When we make an investment in risky and high-growth stocks, we must ensure that preserving our capital by reducing our losses is as important as identifying the fastest growing companies.

What are the pros and cons of the strategy? ⚖️​

The strategy is more than a simple stock investment philosophy: it proposes some specific rules to identify which stocks we should invest in, as well as when to buy and sell. As we've highlighted here before, having a defined stock investing process can help us learn from our mistakes and will reduce the likelihood that we make decisions based on emotion, rather than strategy. And by following the rules of CAN SLIM, we are likely to see the next big winner, as almost all of the fastest growing stocks exhibit these characteristics.

However, the disadvantage is that not all the rules are clearly defined. For example, O'Neil does not specify what constitutes a bear market, how many stocks you should hold in your portfolio, or how much you should invest in each position. Furthermore, following O'Neil's rules would result in high turnover and therefore transaction costs, and would require active management of your portfolio. Finally, investing in the fastest-growing companies works well in the bullish market we've seen over the last decade, but doesn't work as well in bearish or range-bound markets. That makes them a particularly risky bet given that this is exactly where we are now.

In which sector do we make our investment in stocks?​

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

• Energy companies like Earthstone Energy (THIS), Matador Resources (MTDR), New Fortress Energy (NFE) and Pioneer Natural Resources (PXD) have a high score.

Markets from TradingView

• And on the healthcare front, companies like Vertex Pharmaceuticals (VRTX), Eli Lilly (LLY) and Regeneron Pharmaceuticals (REGN) lead the group.

We can make our stock investment in other industries, mind you: car dealership Autonation (AN), waste recycler Darling Ingredients (DAR), and electrical wire maker Encore Wire (WIRE) also fit the bill. Take a closer look at all of these companies, or try applying the CAN SLIM method to other growth stocks, and you might find something you like.