RealMoney Silver - Looking for Strength With the O'Neil Strategy

Looking for Strength With the O'Neil Strategy
By John Reese
RealMoney.com Contributor
9/26/2007 11:34 AM EDT

Those who have followed my recommendations know I pick stocks based on automated strategies I created that use the variables cited by a number of well-known investors, such as Peter Lynch, David Dreman and Martin Zweig.

Many of these strategies have aspects in common, such as seeking reasonable price-to-earnings ratios so as not to overpay for the stock, and looking at growth to be sure the company's prospects are strong. But one of these strategies walks a different path than the others -- the strategy I base on William O'Neil's writings.

This is particularly true when it comes to the price of a stock. Though the adage of "buy low, sell high" is taken as scripture by many, the O'Neil strategy thinks differently. It likes to find stocks that are high today and have momentum behind them. The idea is that these are likely to break out into new territory in the future.

O'Neil is an accomplished investment theorist, technical analyst and founder of Investor's Business Daily. His approach of looking for stocks that are high-priced and likely to go higher gives a technical-analyst cast to his strategy. But he also looks at fundamental variables, such as earnings growth and return on equity.

I have attended some of O'Neil's seminars and have read his books, and I find his approach intriguing. He does not look for "bargains," as so many others do. He believes that low-priced stocks are discounted for a reason -- they are inferior -- and that you are unlikely to make money in the long term buying such stocks. Better to buy quality, he believes, and that means paying high prices.

You cannot expect to buy a top-quality suit or dress or an automobile that will serve you well for many years by paying bottom-dollar prices. Likewise with companies, O'Neil believes. The good companies have stocks that are relatively expensive, but if the company really is a high-quality business, such a price is worthwhile because top companies are most likely to perform well in the long term. O'Neil has plenty of statistics to back up his approach.

I've found several stocks that the O'Neil strategy particularly likes at the moment. One is Under Armour (UA) , which markets technologically advanced athletic apparel and footwear. Its stock price is within 11% of its 52-week high. The strategy wants the current stock price to be at least within 15% of its 52-week high, making Under Armour's price nicely within the strategy's parameters.

The strategy also looks for annual earnings growth of at least 18% (Under Armour's is 44.95%); earnings that increased in at least four out of the last five years (which is true for Under Armour); and a relative strength -- a measure of a stock's performance in comparison to the overall market -- of at least 80, and Under Armour's relative strength is 86. The company also has almost no debt, and its return on equity is a robust 21.6%, both variable in UA's favor.

Dolby Laboratories (DLB) , the well-known developer of audio technology used in home and movie theater sound systems, is another O'Neil strategy favorite. Its annual earnings growth during the past five years has been a sizzling 64.55%, while earnings per share has gone up in each of the past five years. Its stock price is just within 15% of its 52-week high. The company's relative strength is a strong 89, and its industry has 38 companies with a relative strength of 80 or more, indicating this is a desirable industry to invest in. Further, debt is low and return on equity is an acceptable 19.0%.

Another company that is widely known, even if its products are sought by only a segment of the population, is Smith & Wesson Holding Corp. (SWHC) , the fabled 150-year-old firearms manufacturer. Its current stock price is within 13% of its 52-week high. EPS has increased in four of the past five years, and the company's relative strength is a solid 86. Debt is low relative to equity, and its return on equity is an impressive 25.5%.

Syntel (SYNT) , which provides IT consulting and services, has a stock price that's just 4% below its 52-week high. Earnings growth over the past five years has been 18.76% annually, while EPS has gone up in four of the past five years. The stock's relative strength is a strong 89, and its industry -- computer services -- has 80 companies with a relative strength above 80, indicating this is a very desirable industry. Plus, return on equity is 32.2%, nearly double the 17% minimum set by the strategy.

The last company on today's list is Diamond Offshore Drilling (DO) , a major provider of offshore contract drilling services. This company's stock price is just 2% below its 52-week high. Annual earnings growth has been 32.39% over the past five years and EPS has increased in each of the past five years, showing good consistency. Diamond's relative strength is 87; its industry, oil well services and equipment, has 42 companies with a relative strength at or above 80. Debt is low, while return on equity is a gusher at 36.9%.

The O'Neil strategy, with its emphasis on seeking quality and momentum instead of looking for undervalued stocks, is not for everyone. His strategy goes against the common wisdom (such as "buy low and sell high"), and I find it to be more volatile than most. However, O'Neil has been publishing his Investor's Business Daily for years, he has written a number of books and his following appears large. I think he is worth paying attention to.