Friday, September 27, 1996
The Unemotional Value Approach
by MF DowMan

So you want to start a Dow Approach portfolio and aren't quite sure which variation to use? The Foolish Four? The Beating the Dow 5 or 10? Before you decide, let me tell you about the latest variation on the basic Dow Approach, my Unemotional Value model (companion to my Unemotional Growth model). Of all the models we follow here at The Motley Fool Dow Stock Global Research Consortium, the Unemotional Value (or UV) approach has had the best performance record for the past 35 years.

How Does It Work?

The process is simple. Just as with Michael O'Higgins' Beating the Dow you begin by identifying the ten stocks among the 30 companies in the Dow Jones Industrial Average with the highest dividend yields. Then rank those ten stocks by stock price, from lowest to highest (that is, the cheapest stock goes in the #1 position).

Check to see if the #1 stock (the cheapest of the ten) is also the highest yielding stock. If it is, eliminate it from the list and keep the other nine in order. If the #1 stock is not also the highest yielding stock, then keep it on the list (you'll still have ten stocks).

From that updated list, simply buy the top stocks in equal dollar amounts (as many as you wish, based on your personal portfolio needs) and update them one year later.

For our purposes, we use a lot of acronyms here in The Fool, so let me explain our system for the UV approach. Let's say you're looking to buy four stocks. Obviously, you buy the first four on the UV list and that's what we would call the UV4. The number refers to how many stocks you include, not the position of a certain stock on the list. So, the UV2, then, means the first two stocks on the list.

Incidentally, if you like the idea of juicing your portfolio by doubling up on the stock with the greatest potential (like the Foolish Four approach does), you should double up on the first two stocks on the list (the UV2).

Why Does It Work?

The UV approach is a calculated compromise between the Beating the Dow approach, which always includes the #1 stock, and the Foolish Four (BTD4) method of always excluding the #1 stock. After looking over the 35 years of data compiled by MF Templar for the Dow stocks, a pattern emerged. In the years when the #1 stock was a huge loser (the reason why the BTD4 and Foolish Four plans dump it automatically) were almost always tipped off by the fact that the #1 stock also had an unusually high yield. In fact, the yield was so high relative to the others, and with a price so low, that it signaled a stock in trouble.

While not perfect, this signal has been consistent enough that using it to decide when to exclude the #1 stock and when to keep it has generated much better returns than either of the other two methods.

How Well Does It Work?

Let's look at some performance numbers.

Since 1961, Michael O'Higgins' one-stock strategy (known as the PPP) has compounded at 16.74% annually. That would have turned $10,000 into $2.25 million by the end of 1995 (excluding trading costs and taxes).

Compare that to the UV2 approach (taking the first two stocks on the UV list), which compounded at 21.17% annually during those 35 years. That same $10,000 would have grown to $8.29 million. (There were only four losing years during the thirty-five using this approach, the worst by far being a 21.47% loss in 1990.)

The Beating the Dow 4 (dropping the #1 stock automatically and buying the next four) compounded at 16.33% during that period, turning $10,000 into $1.99 million.

In comparison, the UV4 (taking the first four UV stocks) compounded at 17.72%, turning $10,000 into $3.02 million.

Now the Foolish Four was built upon the BTD4, but doubles the weight of the PPP stock. This approach compounded at 16.82% since 1961, turning $10,000 into $2.31 million. So the UV4 actually performed better than the Foolish Four, even without doubling up on any UV stocks.

But if one were to have used the UV4, though, and doubled up on the first two stocks (like the Foolish Four doubled the PPP), the compound growth rate since 1961 was 18.97%, turning that same $10,000 into $4.37 million.

So let's look at a summary:

                          Value of $10,000
Strategy        CAGR      after 35 years
~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~
PPP             16.74%    $2.25 million
UV2             21.17%    $8.29 million

BTD4            16.33%    $1.99 million
UV4             17.72%    $3.02 million

Fool Four       16.82%    $2.31 million
UV4 (juiced)    18.97%    $4.37 million

Starting in 1971 instead of 1961 (admittedly the 1960s weren't a great decade for the Dow Approaches), all of the compound growth rates would have been several points per year higher, but the relative performance remained consistent. The UV2 still beat the PPP, the UV4 still beat the BTD4, and the UV4 with doubled UV2 still beat the Foolish Four. (The returns from this period range from 21.28% for the BTD4 to 25.45% for the UV2.)

How Safe Is It?

MF Sandy has calculated the Sharpe ratios (a relative measure of safety) for almost all of these approaches, and despite the higher returns for the UV approaches, they also generate these returns with less risk than the other variations. Here are the Sharpe ratios for the same variations, except for one (the higher the number, the better):

UV2           65.35%
PPP          37.84%

UV4           62.09%
BTD4         53.85%

Fool Four    51.21%
UV4 (juiced)  ---- 
      (No figure available, but it would be above
       60% as its two components are both above 60%.)

Conclusion

So, for both total return and risk, the Unemotional Value approach has the best long-term record of any of the other Dow Approaches we've followed here at The Motley Fool. If you're starting a portfolio soon or updating one, this is one to consider for your next year's approach.

Transmitted: 9/27/96