The Daily Dow
Tuesday, September 9, 1997
by Robert Sheard

LEXINGTON, KY. (Sept. 9, 1997) -- The Dow Approaches work on a unique two-part screen, and occasionally, this unusual format lends itself to confusion. The idea of investing in the highest yielding stocks is pretty straightforward and has been proven again and again to be a sound way to find value among large stocks. But why the second screen of low price? And can't the companies manipulate their rankings within the Dow simply by splitting their stock?

Let's look at price first. As Michael O'Higgins explained in his book Beating the Dow, we assume that all ten of the Dow high-yield stocks are reasonable candidates for growth over the next year or two. Because their yields are relatively high, either the company has been hiking its dividend (a good sign of strength) or its price has slumped and is due for a recovery. So we work from the assumption that all ten stocks are good choices, but to narrow the field we want another screen to choose the best of those ten.

As O'Higgins points out, low-priced stocks are typically more volatile than higher-priced stocks. This assertion is supported by research in Norm Fosback's book, Stock Market Logic, where low price turned out to be a good indicator of future high beta (high volatility). In fact, it was an even better predictor of future volatility than was past volatility.

So, by focusing on a group of ten stocks that are all deemed to be good values and should out-perform the market, and then culling out the four or five stocks from that subset that should have the highest volatility, we can enhance the returns over the long run over the simple High-Yield 10 approach. It doesn't work every time, of course, but I'm referring to long-term averages where, as a rule, it has proven effective for the last several decades.

But what about stock splits? Can't they be used to manipulate the rankings? At the first level, no they can't. A company can't boost its yield simply by splitting the stock, because in a typical stock split, the dollar dividend amount is split using the same ratio as is used for the stock price. The dividend yield is completely unaffected by the split. If a stock isn't already among the ten high yielders, then, a split will do nothing to get it there.

If a stock is already in the top ten yielders, however, a split will definitely affect the rankings. But this isn't necessarily a flaw in the system. Again, we're assuming all ten high-yield stocks are good candidates already. So if by lowering its stock price (and raising its potential volatility), a high-yield company moves into the Foolish Four rankings, so much the better for us. It's a sign the company believes its stock will perform well. And in the meantime, we get the relatively high yield and a chance at out-performance in terms of price appreciation. A good deal all the way around.

Incidentally, one of the reasons the turnover rate this year for Foolish Four portfolios is so much higher than normal (100% for some investors updating their portfolios lately) is that a number of the perennial high yielders have split their stocks and moved up in the price rankings. So, don't let stock splits throw you. If it's not a High-Yield 10 stock already, the split doesn't matter to us. If a High-Yield 10 stock splits, so much the better because the lower price might boost the volatility and exaggerate the price recovery. Fool on!

(c) Copyright 1997, The Motley Fool. All rights reserved. This material is for personal use only. Republication and redissemination, including posting to news groups, is expressly prohibited without the prior written consent of The Motley Fool. ________________________________

Stock  Change   Last
--------------------
T    +   1/2   40.69
GM   +1  3/8   67.06
CHV  +   7/8   81.63
MMM  +   1/8   92.19

               Day   Month    Year
        FOOL-4   +1.14%   5.85%  12.11%
        DJIA     +0.21%   3.01%  21.77%
        S&P 500  +0.26%   3.80%  26.04%
        NASDAQ   +0.66%   4.35%  28.29%

    Rec'd   #  Security     In At       Now    Change
   1/2/97  153 Chevron       65.00     81.63    25.58%
   1/2/97  179 Gen. Motor    55.75     67.06    20.29%
   1/2/97  120 3M            83.00     92.19    11.07%
   1/2/97  479 AT&T          41.75     40.69    -2.54%


    Rec'd   #  Security     In At     Value    Change
   1/2/97  153 Chevron     9945.00  12488.63  $2543.63
   1/2/97  179 Gen. Motor  9979.25  12004.19  $2024.94
   1/2/97  120 3M          9960.00  11062.50  $1102.50
   1/2/97  479 AT&T       19998.25  19489.31  -$508.94


                             CASH   $1009.44
                            TOTAL  $56054.07