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Unemotional Value
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,
the Unemotional Value model (companion to my Unemotional Growth model). Of
all the Dow models we follow here at The Motley Fool Dow Stock Global Research
Consortium and Driving Range, 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 of the ten. 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.
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 with the #2 stock), 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, I saw a clear pattern. 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 out of which it grew.
How Well Does It Work?
Let's look at some performance numbers. From 1961 through 1995, Michael
O'Higgins' one-stock strategy (known as the PPP) has compounded at 17.50%
annually. That would have turned $10,000 into $2.83 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 21.60% annually during those 35 years. That same $10,000
would have grown to $9.39 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 16.55% during that period, turning $10,000 into
$2.13 million.
In comparison, the UV4 (taking the first four UV stocks) compounded at 17.93%,
turning $10,000 into $3.21 million.
Now the Foolish Four was built upon the BTD4, but doubles the weight of the
PPP stock. This approach compounded at 17.25% since 1961, turning $10,000
into $2.62 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 19.26%, turning that same $10,000 into $4.76 million.
So let's look at a summary:
Value of $10,000
Strategy CAGR after 35 years
PPP 17.50% $2.83 million
UV2 21.60% $9.39 million
BTD4 16.55% $2.13 million
UV4 17.93% $3.21 million
Fool Four 17.25% $2.62 million
UV4 (juiced) 19.26% $4.76 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 21.58% for the BTD4 to 26.08% for the UV2.)
How Safe Is It?
MF Sandy has calculated the Sharpe ratios (a relative measure of safety)
for 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 (the higher
the number, the better):
UV2 65.35%
PPP 37.84%
UV4 62.09%
BTD4 53.85%
Fool Four 51.21%
UV4+ 64.75%
(UV4+ means the UV4 with a double weighting on the UV2)
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.
Instructions to generate current rankings:
1. Start with the 30 stocks which make up the Dow Jones Industrial Average.
2. Identify the ten with the highest dividend yields. If there is a tie for
the final spot among the ten, break it by choosing the stock with the lower
current price.
3. If the highest-yielding of those ten also has the lowest stock price of
the ten, drop it and proceed with the remaining nine stocks. Otherwise use
all ten for the next step.
4. Sort the remaining stocks in ascending order by current price. That is,
the cheapest of the ten is #1.
5. Choose the five with the lowest prices. If there's a tie for the final
spot, give preference to the stock with the higher yield.
6. Hold for one year.
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