<THE FOOLISH FOUR>

Foolish Four Report
by Robert Sheard

LEXINGTON, KY. (Feb. 12, 1998) -- One of the confusing aspects about the Foolish Four model is that it employs a double screening process. And the second screen leads to a number of questions that crop up regularly, so let's look at the way the nuts and bolts work.

For all of the High Yield Dow approaches, the first screen is based on dividend yield. We identify the ten stocks with the highest dividend yields (yield = annual dollar dividend / stock price per share) and throw out the other twenty stocks.

The high yield relative to the rest of the Dow has been a consistent sign historically of a stock somewhat out of favor among the Dow components. Buying such a stock when no one else really wants it is a way of getting it at a bargain price for the patient investor who can wait until the stock regains Wall Street's attention. Then it's time to sell and move on again. This basic "Dogs of the Dow" approach has worked for as long as anyone has tested it (back to the 1920s).

But over time, a number of researchers noticed that by refining the list of ten a little further, one could even improve the returns over this already market-beating approach. The simple test to choose those stocks is the second screen we use, low stock price. Why low stock price and not something like P/E ratio or Price/Sales ratio?

As Norm Fosback, author of Stock Market Logic, and others have pointed out, there is a demonstrable correlation between low price and future volatility (or beta). Lower-priced stocks are simply more volatile as a rule than higher-priced stocks.

Given that we assume all ten high yielders are good candidates for appreciation, by focusing on the ones within that group of ten that might be the most volatile improves our odds. And history has borne this out. The Beating the Dow approach (which chooses the five lowest-priced stocks of the ten high yielders) has surpassed the straight HY10 approach for decades. (Since 1971, the HY10 has averaged 17.5% a year while the BTD5 has averaged 19.2%. The Dow30, meanwhile, has averaged 13.7%.)

But the dual screen can make for some interesting movements in our Foolish Four rankings. It's possible for a stock to be among the Foolish Four one day and disappear altogether from the list of ten Beating the Dow (or High Yield) stocks the next. Keep in mind that the first test is high yield. It's possible that the stock in the tenth position on the high yield list will be ranked very high on the list when it's re-sorted by stock price. If that stock slips a place on the high-yield list, it falls entirely out of the group, even though it was very high on the list sorted by price the day before.

Another question concerns stock splits. Doesn't a stock split place a stock in the group artificially? No. When a stock splits its price, it also splits its dividend by the same proportion, so the dividend yield is unaffected. Unless a stock is already in the HY10, a split won't put it there.

If a stock is already in the HY10, though, a split will definitely move it higher in the rankings based on price. That's not a flaw, though. At its lower price, the stock is likely to become a bit more volatile, and thus, more attractive to us.

So don't be baffled by the appearance or disappearance of a stock from the Foolish Four rankings. A small change in the yield can be enough to cause the shift. And don't worry about stock splits; they don't muck up the process either. Fool on!

[Still confused about the changes to the Foolish Four? Visit our special collection which explains why the Fools have modified our beloved Dow Approach.]

[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.]

TODAY'S NUMBERS
Stock  Change   Last 
 -------------------- 
 UK   -   9/16  47.94 
 IP   -   3/16  48.00 
 MO   +   1/16  42.63 
 EK   +   3/16  66.88 
 
            
                    Day   Month    Year 
         FOOL-4   -0.30%   4.94%   6.88% 
         DJIA     +0.66%   5.86%   5.83% 
         S&P 500  +0.40%   4.47%   5.53% 
         NASDAQ   +0.34%   5.87%   9.17% 
  
     Rec'd   #  Security     In At       Now    Change 
  
  12/31/97  291 Union Carb    42.94     47.94    11.64% 
  12/31/97  289 Int'l Pape    43.13     48.00    11.30% 
  12/31/97  206 Eastman Ko    60.56     66.88    10.42% 
  12/31/97  276 Philip Mor    45.25     42.63    -5.80% 
  
  
     Rec'd   #  Security     In At     Value    Change 
  
  12/31/97  291 Union Carb 12494.81  13949.81  $1455.00 
  12/31/97  289 Int'l Pape 12463.13  13872.00  $1408.88 
  12/31/97  206 Eastman Ko 12475.88  13776.25  $1300.38 
  12/31/97  276 Philip Mor 12489.00  11764.50  -$724.50 
  
  
                              CASH     $77.19 
                             TOTAL  $53439.75