S is for Supply and Demand

"The law of supply and demand is more important than all the analyst opinions on Wall Street."

- William J. O'Neil

Two little words - supply and demand! Understand them and their import and you understand the market, whether it be the corner grocery store or the stock market. And these concepts are the fourth criteria in William O'Neil's CANSLIM approach to selecting winning growth stocks.

Supply: the more of something that is available on the market, the lower the price will be. The scarcer an item is, the higher the price will be.

Demand: the more people that want something, the higher the price of that thing will be. The fewer people that want it, the lower the price will be.

It's not rocket science. And yet, investors commonly overlook these simple concepts in making their investing decisions. How do they apply to stock selection? Let's look first at supply.

Supply

The easiest way to look at the supply side of the equation is to see how many shares of a company are outstanding. If all other factors are equal, a company with a smaller number of shares on the market will do better than one with a larger number of shares.

In his 40 year study of stock market winners, O'Neil found that 95% of them had fewer than 25 million shares outstanding. In fact, the average number of shares for this crop was 11.8 million shares. And the median was 4.6 million shares. That means that half of the companies in O'Neil's study had less than 4.6 million shares.

Companies sometimes raise additional capital by issuing new stock. Often such new issues are sold by private placement at a lower price than the stock's market price. This increases the supply of stock and dilutes the value of the company over more owners. If the capital raised is put to good productive use to make the company grow, it can be beneficial. But if the company is using the issuing of new shares as a stop-gap to keep the company afloat, watch out!

Stock Splits

It is generally believed that stock splits are a good thing. A stock split does not dilute the value of the company for current shareholders as each will just have more shares. But O'Neil questions the wisdom of this practice all the same.

Corporations split their shares after a run-up in price believing that this will make the stock more affordable and attract more buyers. To a limited extent, this may well be true. People tend to buy stocks in board lots. But this is not necessary. People can and do buy stocks in smaller amounts. I certainly do. The fewest number of shares I ever bought was two. Of course, they were Baby Berkshires. But that illustrates the point perfectly.

Warren Buffett, arguably one of the greatest investors that ever lived, has never split his Berkshire Hathaway stock. The Class "A" stock closed on April 5, 2000 at $56,700 and has been as high as $78,600. The failure to split the stock did not hinder Berkshire Hathaway's growth over the last four decades.

Buffett did introduce Class "B" shares eventually to make the stock affordable to a wider number of investors. But even these Baby Berkshires closed at $1838, the second most expensive stock on the NYSE after the Class "A" shares.

And, as O'Neil points out, while a cheaper stock price may attract more buyers, it also makes it easier for institutional owners of large blocks of shares to sell off part of their holdings. He notes that shrewd traders will often sell into the good news of a stock split knowing the price may well drop back afterwards. He notes that a stock often tops out after the second or third split.

There are exceptions. Microsoft had many stock splits and kept growing and growing. But exceptions do not make the rule.

Buybacks

While stock splits increase the supply of shares available, companies sometimes contract the supply by buying back their own shares on the open market. These shares are then retired to the treasury and are not taken into consideration when calculating earnings per share. The result: earnings per share go up. And as noted in the "C" part of the CANSLIM formula, increasing earnings per share are a principal driving force behind share price growth.

Companies that believe their shares are undervalued will often buy back shares specifically with the objective of driving up share price. They will usually issue a press release to this effect. In Canada, buybacks are called "normal course issuer bids" and are required to be publicly announced.

While not strictly a supply and demand factor, O'Neil points out that the makeup of the ownership of a stock can be very important. He says that "stocks that have a large percentage of ownership by top management are generally your best prospects". When company management has a vested interest in the share price, they will tend to be more entrepreneurial rather than bureaucratic.

Demand

On the demand side, look for trading volume to go up as a stock's price starts to rise. There will usually be a spike in volume as a stock reaches an interim high.

After a run-up a stock's price will consolidate and form a new base price. During this consolidation phase, the volume should dry up.

A danger sign would be if the price leveled off or dropped but volume stayed high. This would mean that holders of the stock were keen to take profits. They lacked confidence that the company would continue to do well. Rats deserting a sinking ship might be an apt comparison.

Determining Supply and Demand

As noted above, you can determine the supply of a stock by simply checking out the company and seeing how many shares are outstanding. You can watch for signs of dilution - the issuing of new shares, or the increase of supply by stock split. You can watch for companies that are buying back shares and reducing supply.

On the demand side, you can monitor trading volume and determine whether a price increase was the result of a speculative run-up or solid fundamentals. There are a number of useful resources you can find on the Internet.

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