Tuesday, November 25, 1997

The Daily Dow
by Robert Sheard

LEXINGTON, KY. (Nov. 25, 1997) -- If you've spent any time at all browsing through our materials in the Dow Area, including the Current Dow Order and 1997 Dow Returns files, you've probably been frustrated by the plethora of acronyms we're forced into using to distinguish among the numerous variations on the basic High Yield strategy.

Today I'll profile my own addition to the Dow Dog Pile (I think we should rename the area), the Unemotional Value approach (UV). The basic Beating the Dow model takes the ten highest-yielding Dow stocks and selects the five with the lowest prices -- a straightforward two-part screen.

After much Foolish number crunching in 1995 and 1996, however, it became apparent that the cheapest of those stocks was occasionally a stock in real financial trouble. The subsequent losses it recorded in some of those years were enough to lower the long-term returns for the cheapest stock sufficiently that skipping it altogether seemed to represent a better approach. (Buying the second, third, fourth, and fifth stocks on the Beating the Dow list is what we designate the BTD4.)

The Foolish Four model is based on these four choices, with the added twist of increasing the weight of the #2 stock, which historically has produced the best gains of any single position among the ten.

But this approach only recognized half of the dynamic involved in that cheapest stock. It turns out that in many years, the cheapest stock is actually a terrific performer and it is only occasionally that it represented a disaster holding. The problem was how to identify the difference ahead of time.

What I noticed in the history since 1961 is that a lot of those disasters were in stocks that were not just the cheapest of the High Yield Ten, but the stock was also the highest yielder as well. Apparently like any good thing, too much of it can be bad for you. When a stock is the highest yielder on the Dow and the lowest-priced stock of the High Yield Ten, it's typically the kind of red flag that signals a possible impending disaster.

Enter Unemotional Value. Instead of skipping that #1 stock automatically, I tested a method where one only skipped it in years when it was also the highest yielder. And while the results in every year when this scenario was in effect didn't come out perfectly, the results overall were significantly better than those registered by skipping the #1 stock automatically every year.

For example, over the 36-year life of our Dow database, from 1961-1996, the BTD4 has recorded an annualized return of 16.93%. Doubling the weight of the #2 stock (the Foolish Four model) has increased the overall returns of such an approach less than one point per year, to 17.44% (more on this factor later.)

The Unemotional Value four-stock approach, however, has returned 18.11% without any over-weighting of any positions. In fact, and this is key in my mind, the UV4 even beats the much-vaunted single-stock approach known as the Penultimate Profit Prospect (the #2 stock all by itself). Since 1961, the PPP stock has only returned 17.80% per year.

So while the PPP stock does occasionally hit home runs, it can go for long periods without helping the portfolio at all. For example, over the last ten years, the PPP returns have trailed those generated by all three four-stock models (the BTD4, the Foolish Four, and the UV4). Given that doubling that PPP stock as part of the Foolish Four approach also increases the risk associated with that single stock (it becomes 40% of your holdings), I don't think the hoped for occasional home run justifies the extra risk.

Another way to look at this risk factor is how much of a loss the single stock can inflict on your total portfolio if the PPP craters. If the PPP stock gets sliced in half and it makes up 40% of your overall portfolio, the entire portfolio suffers a 20% loss. In fact, that represents more risk attached to a single stock than if you bought the four stocks in equal-dollar amounts and leveraged the entire portfolio with 20% on margin (an advanced and admittedly higher-risk strategy I've advocated for some situations). The loss for such a margined portfolio if a single stock gets sliced in half is 15.625% -- still painful of course, but less of a risk per stock than for the over-weighted PPP stock in the Foolish Four.

One more strike against the PPP is that it also significantly loses out historically to a two-stock UV approach. Since 1961, the PPP stock has returned an annualized 17.80%, but the UV2 has recorded a 21.54% annualized return over the same 36 years. While I still don't advocate a two-stock approach, if you put a gun to my head and forced me to choose one or the other I'd definitely opt for the UV2 over the PPP approach.

So, how can you quickly identify the UV stocks? Click to our Current Dow Order file, which I update daily. You'll see two lists of ten stocks side-by-side. On the left are the top ten yielders sorted in descending order by yield. The list on the right includes the same ten stocks in ascending order by share price (the BTD order).

Look at the first stock in each list. If it's the same company, as it is today with Philip Morris <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: MO)") else Response.Write("(NYSE: MO)") end if %>, throw it out and take the next four, five, or however many you wish from the list on the right (the BTD order). If the top stocks in each list are different, don't throw anything out and choose the top stocks from the BTD Order list. It's that simple.

Is it perfect? Nope. Will it return 18% a year for the next 35 years? No one knows. But it's worked very well for decades with both strong and weak markets, posting average annual returns of nearly five percentage points better than our benchmark portfolio of the thirty Dow stocks. Over time, such out-performance can generate an amazing difference in portfolio growth. For example, it would be the difference between turning $10,000 into $900,000 over 36 years (before taxes) and turning $10,000 into $4 million.

There you have it -- the Unemotional Value variation of our basic Dow Dividend Approach. If you're looking for a core approach to your portfolio, include four or five Dow stocks using an approach like this (I use equal-dollar amounts for each stock in my own portfolio) and then spend the rest of your stock research time looking for growth stocks to layer on top of the Dow heavyweights. Fool on!

TODAY'S NUMBERS

Stock Change Last -------------------- T +1 1/8 55.44 GM - 3/8 60.69 CHV -1 7/8 81.00 MMM +1 9/16 97.25

Day Month Year FOOL-4 +0.60% 5.22% 25.78% DJIA +0.53% 4.93% 21.10% S&P 500 +0.44% 3.96% 28.36% NASDAQ +0.13% -0.29% 23.08% Rec'd # Security In At Now Change 1/2/97 479 AT&T 41.75 55.44 32.78% 1/2/97 153 Chevron 65.00 81.00 24.62% 1/2/97 120 3M 83.00 97.25 17.17% 1/2/97 179 Gen. Motor 55.75 60.69 8.86% Rec'd # Security In At Value Change 1/2/97 479 AT&T 19998.25 26554.56 $6556.31 1/2/97 153 Chevron 9945.00 12393.00 $2448.00 1/2/97 120 3M 9960.00 11670.00 $1710.00 1/2/97 179 Gen. Motor 9979.25 10863.06 $883.81 CASH $1409.35 TOTAL $62889.98