“It takes something new to produce a startling advance in the price of a stock,” William J. O’Neil wrote in chapter five of his 2009 book “How to Make Money in Stocks: A Winning System in Good Times and Bad.”
That something new could be newer companies, a new product or products, new management that reinvigorates a company, new industry conditions or new highs taking off from properly formed chart patterns. In short, catalysts that bring something new and significant to a company is a rich source of high-potential stock names.
It could also be revolutionary new technologies, such as those behind the FAANG stocks, that create value for shareholders. The FAANG stocks—Facebook (FB, Financial), Amazon (AMZN, Financial), Apple (AAPL, Financial), Netflix (NFLX, Financial) and Alphabet's Google (GOOG, Financial)(GOOGL, Financial)—have provided super success stories for modern investors.
But new products and outsized gains have gone together for as long as stock markets have existed. O’Neil’s research showed that 95% of the big winners in more than a century of investment history also depended on revolutionary new products or services:
- In the late 1800s, the railways disrupted conventional shipping and generated outstanding returns for investors (even after making allowances for the many scams that went along with early investing).
- Electricity, too, was a radical new product early in the 20th century, one which made many investors rich.
- In the mid-20th century, investors who captured the huge popularity of television, jet aircraft and more were massively rewarded.
Here are some specific examples of radically new products that boosted markets and the fortunes of investors:
- RCA, the original radio company, and a subsidiary of General Electric (GE, Financial) since 1986: It had captured the commercial radio market by 1926 and its stock went up from $50 to $575 in the couple of years before the stock market collapsed in 1929.
- As franchising took root at McDonald’s (MCD) between 1967 and 1971, its share price rocketed 1,100%.
- Hansen Natural, now Monster Beverage (MNST, Financial), introduced its drinks in the early 2000s, and its stock price shot up 1,219% in slightly more than a year and a half.
If you are disappointed you missed out on the great successes of the recent past, O’Neil reminded readers that revolutionary new products keep launching and the stocks behind them will be available too.
In the second section of chapter five, the author introduced the “Great Paradox,” something he said he had found in the early stages of “all winning stocks.” That paradox is, “What seems too high in price and risky to the majority usually goes higher eventually, and what seems low and cheap usually goes lower.”
As an aside, when O’Neil talked about cheap stocks, he seeks to use the concept differently than value investors would. He is talking about the kinds of stocks Warren Buffett (Trades, Portfolio) called “cigar-butt” stocks, really cheap stocks that did not necessarily have any intrinsic value. Modern value investors, on the other hand, may be buying cheap stocks, but that cheapness is always relative to higher underlying value.
Having ruled out bargain buying, O’Neil made his case for buying at new highs, particularly when the new high is accompanied by big increases in the number of shares being traded. As he put it, “As a smart investor, your job is to buy when a stock looks too high to the majority of conventional investors and sell after it moves substantially higher and finally begins to look attractive to some of those same investors.”
Growth investing, or momentum investing, then is his style of choice. But hitting a new high is not enough by itself. As noted, big volume can help confirm a real price movement. For O’Neil, the most important development is shown on a stock chart. Prices breaking out of proper bases, such as “cup and handle” formations, are the key.
He wrote the perfect time to buy is during a bull market, when the stock is starting to break out of its price base (the flat area on a stock chart). What’s more, he argued that if a share price is more than 10% above its base, then it should be avoided because of the danger of being “shaken out” in the next correction or sharp pullback.
O’Neil summed up the chapter this way: “Search for companies that have developed important new products or services, or that have benefited from new management or materially improved industry conditions. Then buy their stocks when they are emerging from sound, correctly analyzed price consolidation patterns and are close to, or actually making, new price highs on increased volume.”
For value investors, the idea of searching for companies with new products, new management and so on is a good idea. However, investors who go this route will face the challenge of establishing an intrinsic value, since it will be difficult to assign future values to cash flows. Without a realistic notion of intrinsic value, investors may take on more risk than they should.
Regarding decisions based on technical analysis, I remain an agnostic. I simply do not know enough to recommend or discourage buying or selling based on O’Neil’s ideas.
(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
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