The Motley Fool: The Foolish Workshop, Thursday, February 05, 1998

Thursday, February 05, 1998

The Daily Workshop Report
by Robert Sheard (TMF Sheard)

LEXINGTON, KY. (Feb. 5, 1998) -- Last week in my Foolish Four column I wrote about a Fool-of-the-Month Portfolio plan whereby the investor adds one new stock according to the rankings each month for a year. At the end of one year, the investor holds twelve highly-ranked stocks and can begin updating one holding each month according to the current rankings.

This allows for plenty of diversity among large-cap stocks but also constantly picks up a high-ranked stock without increasing commission costs or piling up short-term gains. Also, for the investor who saves regularly, this allows him to add new money every month as one of the twelve stocks gets replaced. You'll be limited to 24 trades a year, which keeps total trading costs around $200, easily affordable by a $12,000 portfolio ($1,000 minimum in each position).

This approach, of course, would work nicely with the Keystone Approach as well, so I thought it would be worthwhile to follow it in this column. I'll have to back into January's and February's "purchases," but that's easy enough to do.

Here's the scenario. The Keystone-a-Month Portfolio would have begun on 12/31/97 with $12,000. Each month it purchases the highest-ranked Keystone stock not already in the portfolio. Commissions will be accounted for at $8 per trade. While the bulk of the money is waiting to be invested in Keystone stocks the first year, it will be invested in the S&P 500 Index Spyder <% if gsSubBrand = "aolsnapshot" then Response.Write("(AMEX: SPY)") else Response.Write("(AMEX: SPY)") end if %>. Each month as we add a new Keystone stock, we'll sell enough shares of the Spyder to cover the new stock purchase. After we've invested in twelve keystone stocks, we'll begin replacing the original stocks -- one per month.

Let's see where we would have been so far. On 12/31/97, the top-ranked Keystone stock was Fifth Third Bancorp <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: FITB)") else Response.Write("(Nasdaq: FITB)") end if %>. With our first $1,000, we'd have been able to purchase 12 shares of FITB at $81.75 a share. With the $8 commission, that's a cost of $989. With the remaining $11,011, we would have been able to buy 113 shares of the Spyder at $96.875 each. After the two purchases and commissions, we'd have $56.13 left over in cash.

On to the end of the first month. The top-ranked Keystone stock at the end of January was Schering-Plough <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: SGP)") else Response.Write("(NYSE: SGP)") end if %>. In order to invest $1,000 in Schering-Plough, we would have had to sell 10 shares of the Spyder at $98.3125. After the commission, that nets us $975.13, leaving us $1031.25 in cash overall.

With that, we could afford 14 shares of Schering-Plough at $72.375. After the trade and commission, we would have $10.00 left in cash.

At the close yesterday, then, here's what the Keystone-A-Month Portfolio holds:

Shares  Stock   Price       Value 
     12   FITB    78.44     941.25 
     14    SGP    73.00   1,022.00  
    103    SPY   100.69  10,370.81 
          Cash               10.00 
 ----------------------------------- 
           Total         12,344.06 
          Return             +2.9%

Let's look at the advantages and disadvantages of such a strategy. First the downside. It requires you to make one transaction each month -- twelve times as much of a time commitment as the usual once-a-year plan, but hardly a burden. In fact, many of you have expressed anxiety about having "nothing to do" for a whole year. This would give you more activity without turning you into short-term traders.

A more important consideration, however, is that during the first year, you will pay short-term capital gains taxes on the sales of the Spyder each month as you're funding your initial twelve stocks. After that, of course, all stocks are held a full year (and a day if you need to qualify for the one-year holding period). This is only a drawback, however, if you're in a tax bracket higher than 28%. It's a short-term, one-year problem, however. For investors in the 15% and 28% tax brackets, it's not an issue at all because all gains are taxed at your ordinary tax rate until you get into the 18-month holding period, which doesn't match up with Keystone well.

The advantages, as far as I can see, vastly outweigh the drawbacks. First, you're ultimately holding twelve top-ranked large-cap growth stocks. That's plenty of diversity in my opinion. In addition, each stock you buy is ranked very highly in the Keystone rankings; historically, the top-ranked stocks have significantly outperformed those lower on the list, even though the entire list of 30 has out-performed the S&P 500 over the last dozen years. In the twelve years of data I have, for example, the top-ranked stock averaged some 36% a year, even with a blow-out loss of more than 20% in 1990 by General Motors <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: GM)") else Response.Write("(NYSE: GM)") end if %>. Not every stock will follow that pattern, naturally, but the law of averages is in your favor. And since you're holding twelve of these highly ranked stocks, your portfolio doesn't rest on the fortunes of a single stock.

Commissions and taxes are minimized. If you begin with $12,000, your commissions will be at most about 1.6%. That cost ratio will continue to fall as your portfolio grows. All stocks are held for one year (and a day if necessary), so the maximum tax rate is 28%. And by having one stock come due for renewal each month, regular savers have twelve opportunities a year to add new money.

So follow along with this portfolio. I'll keep you posted once a week or so. And if you have a better name for it than Keystone-A-Month, please pass it along. Fool on!

[Want to be the first Fool on your block to get a copy of Robert Sheard's forthcoming book? Click here to pre-order your copy of The Unemotional Investor.]