<THE FOOLISH FOUR>

Foolish Four Report
by Robert Sheard

LEXINGTON, KY. (Mar. 11, 1998) -- I've been asked to write another column on a topic I've written about many times in the past, but it's good to revisit the topic occasionally as we get new readers coming to the Dow area regularly. The big question on some new readers' minds is whether the Foolish Four is such a good approach by the time you penalize it each year for capital gains taxes. Wouldn't an investor simply be better off holding an S&P 500 Index fund and deferring those taxes?

Let's look first at the assumptions I have to use in such a comparison. We all know the drill on history being no guarantee of future returns, but I think ignoring historical trends is silly, and as they're all we've got, let's use them. (Besides, the gooroos who claim back-tested results are irrelevant are the same talking heads who pontificate about it "never being different this time." What're you gonna do?)

So, history is our guide here, for better or worse. In the 27 years from 1971, the Foolish Four has had an annualized return of 22.0%. Over the same stretch, the S&P 500 Index (with dividends reinvested) has returned 11.9% a year (according to Ibbotson Assoc.).

In addition, since what we're really trying to measure is the effect of current tax rates, forget what existed in the past and let's focus on our current system. Assume that the entire Foolish Four portfolio turns over every 366 days and our taxpayer is in the 28% tax bracket. In other words, both the capital gains and the dividends are taxed every year at 28%.

For the S&P 500 Index, let's assume that there are no annual taxable distributions and that the entire gain is tax-deferred until the end of our test period. At that time, the gain will be taxed at 18%, the new tax rate that comes into effect in a few years for issues held more than five years.

Neither of these assumptions is accurate; the Foolish Four does not turn over entirely each year and the index funds do distribute dividends and taxable gains each year. But as both assumptions are stacked in favor of the index alternative, I'm prepared to use them for the purposes of this comparison.

Let's start with the index fund. Let's invest $25,000 for the next 30 years (completely arbitrary numbers; pick anything you like and the basic comparison isn't changed) at the growth rate of 11.9% a year. After 30 years, the original $25,000 will have grown to $729,193.

Now let's back out the taxes still owed to Uncle Sam. Of the total amount, $704,193 is taxable as capital gains. Take out the tax at 18% and you owe $126,755 to the federal government. That leaves a final portfolio value of $602,438.

Now let's calculate the same investment in a taxable Foolish Four portfolio. (Of course, if you're using the Foolish Four in a tax-advantaged account, so much the better.) With a pre-tax return of 22.0% and a tax rate each year of 28%, the after-tax return is 15.8% per year. Since the pre-tax return of the index is only 11.9%, there's obviously not going to be a challenge to the Foolish Four, but let's carry the numbers out anyway just to show the marked difference.

Take the $25,000 and calculate the growth for 30 years at 15.8% (the after-tax annual rate), and the Foolish Four investor's portfolio climbs to $2,037,965. That final value for the Foolish Four scenario is more than 238% larger than the buy-and-hold approach with an index fund and deferred taxes.

Now, you may argue that buying individual stocks and holding them for 30 years might well do better than the index. And you're right that it's possible. But do you know which stocks to hold for the next 30 years to get there? I don't. But I can tell you what the Foolish Four stocks are today, and again in a year, and again a year after that.

The point is that the Foolish Four strategy, even after you account for full taxation, has been a consistently stronger alternative to buying-and-holding forever. And moreover, everyone can do it. You're going to save money on taxes using buy and hold, no doubt. But are you more concerned about avoiding taxes or your total after-tax return? As much as we all hate taxes, if we're keeping more after we pay them with a strategy like the Foolish Four, what's to complain about? 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.]

TODAY'S NUMBERS
Stock  Change   Last 
 -------------------- 
 UK   +   5/8   47.75 
 IP   +1  7/16  51.88 
 MO   +   9/16  44.56 
 EK   -   1/16  63.00 
 
 
                    Day   Month    Year 
         FOOL-4   +1.38%   3.17%   8.48% 
         DJIA     +0.38%   1.52%   9.71% 
         S&P 500  +0.39%   1.82%  10.10% 
         NASDAQ   +0.48%  -0.77%  11.87% 
  
     Rec'd   #  Security     In At       Now    Change 
  
  12/31/97  289 Int'l Pape    43.13     51.88    20.29% 
  12/31/97  291 Union Carb    42.94     47.75    11.21% 
  12/31/97  206 Eastman Ko    60.56     63.00     4.02% 
  12/31/97  276 Philip Mor    45.25     44.56    -1.52% 
  
  
     Rec'd   #  Security     In At     Value    Change 
  
  12/31/97  289 Int'l Pape 12463.13  14991.88  $2528.75 
  12/31/97  291 Union Carb 12494.81  13895.25  $1400.44 
  12/31/97  206 Eastman Ko 12475.88  12978.00   $502.13 
  12/31/97  276 Philip Mor 12489.00  12299.25  -$189.75 
  
  
                              CASH     $77.19 
                             TOTAL  $54241.57