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One of the Fool's first message boards was devoted to discussing Beating the Dow, written by Michael O'Higgins. The BTD message board community quickly became very active speculating on ways to improve on OHiggins's system. The Beating the Dow strategy selects the 10 highest yielding stocks from the 30 Dow Jones Industrial Average stocks and ranks them by price. The BTD 5 is the five lowest priced stocks on that list. The BTD strategy called for buying these stocks and holding for one year, then renewing the portfolio with the current BTD 5.
Unfortunately, data to test alternatives was not included in Beating the Dow. The book lists strategy returns but not individual component stock returns. Board participant Ann Coleman managed to get the yearly returns for the High Yield 10 stocks and their price order from Beating the Dow co-author John Downes, and using that data, she developed a spreadsheet to test some of the questions that were plaguing the message board.
O'Higgins had stated in Beating the Dow that the lowest priced stock was often a company in financial trouble but that the second lowest priced stock was frequently an outstanding performer. He even based a one-stock strategy, the PPP (Penultimate Profit Prospect) on that second lowest priced stock. Board participants wondered about this discrepancy. The first spreadsheet revealed that the lowest stock was indeed a dangerous proposition, underperforming the Dow as a whole. This brought up an interesting question that remains unanswered to this day: Why did O'Higgins suggest buying it in the first place?
Finding that the first stock was a loser and verifying the outstanding performance of the second lowest priced stock lead to the formulation of three strategies that beat Beating the Dow's BTD 5 (Average Annual Return 1973-1993 of 19.59%*). The BTD 2-5 (22.11%), BTD 2-6 (20.45%), and 2,2,3,4,5 (23.77%). 2,2,3,4,5 boosted returns by dropping the lowest priced stock and doubling up on the PPP. This is the strategy described by the Gardners in The Motley Fool Investment Guide (published in January 1996) and used in the Fool Portfolio when they made their annual Beating the Dow switch in August 1996. It was also the strategy used in the Foolish Four "virtual portfolio" that started in January 1996.
In the three full years since it was first published (1995-1997), Foolish 4.0 returned an average of 30.64% compared to the BTD 5's return of 24.70%. The strategy's 25-year compounded average annual return (1973-1997) is 23.17%.
In August of 1997, the short lived and unmourned 18-month holding period to qualify for long-term capital gains was in effect, so the Fool Portfolio's annual switch was delayed until February of 1998, by which time Foolish 4.1 had come along.
*A note on these numbers: The returns quoted here are Compound Annual Growth Rates (compounded Average Annual Returns) for each strategy. We used the returns starting with 1973 because Beating the Dow (1992 edition) is based on data starting in 1973. The first set of returns goes from 1973 through 1993. 1993 was the cut off because that was the last year of full returns available for research when the original Foolish Four was developed.
These returns won't match those in Beating the Dow because they include two additional years and because BTD uses a December 31 renewal data while our spreadsheet uses a January 2 renewal date. They are all directly comparable with other returns quoted here, however, and they are very close to the BTD returns quoted at the end of the book, which covers 1973-1991.
The recent returns start in 1995 because that was the first full year during which the original Foolish Four strategy could be used. It happens that 1994, which is left out of each of these periods, was also a rather bad year for investing, but that's not why it was left out. It just happened to be the watershed year. It is included in the 25-year compound returns, of course.