<THE FOOLISH FOUR>

Foolish Four Report
by Robert Sheard

LEXINGTON, KY. (April 15, 1998) -- Veteran Fools may find my columns today and tomorrow old news and should consider putting the Evelyn Woods course to the test. We've had so many new readers visit this area that I'd like to turn my focus to the basics of High-Yield investing and talk about the actual mechanical screens themselves. A nuts-and-bolts pair of days, as it were.

Essentially, there are three ways to approach high-yield investing with the thirty Dow components. I'll address the first two today (the High-Yield approach and the Foolish Four), and tomorrow I'll cover the third (the RP Variation).

The High-Yield approach (sometimes also called the Dogs of the Dow) is the simplest and most conservative of the three approaches. Focusing on high-yielding stocks in the Dow (a market culture where dividends are generally treated almost as sacred rights of the shareholders) allows us to identify the most out-of-favor companies, ones where the stock price may be depressed temporarily. The High Yield investor buys these out-of-favor stocks and holds patiently for the inevitable recovery period. It's the very essence of "buying low and selling high."

The method one uses is simply to identify the ten stocks in the Dow Jones Industrial Average with the highest dividend yields. (The dividend yield is calculated by dividing a stock's annual dollar dividend per share by the stock's current price per share.)

Once the ten highest-yielding Dow stocks are identified, one buys all ten in equal-dollar amounts and holds them for at least one year. At that time, the portfolio is adjusted so that the new list of the High-Yield ten is included in equal-dollar amounts and held for the next cycle. The approach couldn't be simpler, and the dividend yield information is readily available daily, both online in The Motley Fool and in print resources like The Wall Street Journal.

For a conservative, low-maintenance, low-stress approach, the straight High-Yield 10 has done very well. From 1971 through 1997, the HY10 has achieved an annualized return of 17.5%, turning $10,000 into $771,000. Over the same stretch, an equally weighted basket of all thirty Dow stocks returned just 13.7% per year.

The second of the three main approaches, the Foolish Four, takes the simple High-Yield model one step further. While the results for the basic HY10 are impressive, they pale in comparison to the Foolish Four model, which adds a second ordering screen to the process.

Once one has identified the HY10, make a second list of those ten stocks, ranking the stocks in ascending order by stock price per share. That is, the lowest-priced stock in the HY10 is #1 on this second list, the highest-priced stock, #10.

Compare the two lists (high yield and low price). If the same stock is #1 on both lists, scratch it off the list. The Foolish Four stocks are the top four on the low-price list. If when you compare the two lists, different stocks top each one, nothing gets discarded and the Foolish Four are simply the top four stocks on the low-price list.

Buy the four stocks in equal-dollar amounts, just as one would with the high-yield approach, and hold for at least a year. Then reconstitute the portfolio to hold the new Foolish Four stocks at that time.

From 1971 through 1997, the Foolish Four approach has returned an annualized gain of 22.0%. Instead of $771,000 with the High-Yield Approach, our hypothetical $10,000 invested in 1971 in the Foolish Four would have grown to more than $2.1 million.

The reason the second, low-price screen improves the performance of the basic High-Yield Approach is that there is a demonstrable correlation between lower-priced stocks and future volatility. Since the assumption we're making is that the first screen (the ten highest yielding stocks) has already identified ten good candidates for appreciation, we want to court future volatility because it's likely to be positive volatility. Focusing on four potentially more volatile stocks out of the original ten out-of-favor high yielders tightens the model and generates better long-term returns.

In tomorrow's column, I'll present the third basic approach, the RP Variation, which combines the high-yield and low-price elements into a single ratio to be applied to all 30 Dow stocks. Until then, Fool on!

Current Dow Order | 1998 Dow Returns

[Robert Sheard is the author of the forthcoming book, The Unemotional Investor, due out from Simon & Schuster on May 12. To pre-order your copy, please visit Amazon.com, where it's available at a discounted price.]

TODAY'S NUMBERS
Stock  Change   Last 
 -------------------- 
 UK   +   3/8   51.50 
 IP   -  13/16  53.56 
 MO   -   1/8   40.13 
 EK   +1  1/8   71.94 
 
 
                    Day   Month    Year 
         FOOL-4   +0.13%   6.32%  13.55% 
         DJIA     +0.57%   4.12%  15.86% 
         S&P 500  +0.32%   1.59%  15.34% 
         NASDAQ   +1.10%   1.50%  18.65% 
  
     Rec'd   #  Security     In At       Now    Change 
  
  12/31/97  289 Int'l Pape    43.13     53.56    24.20% 
  12/31/97  291 Union Carb    42.94     51.50    19.94% 
  12/31/97  206 Eastman Ko    60.56     71.94    18.78% 
  12/31/97  276 Philip Mor    45.25     40.13   -11.33% 
  
  
     Rec'd   #  Security     In At     Value    Change 
  
  12/31/97  289 Int'l Pape 12463.13  15479.56  $3016.44 
  12/31/97  291 Union Carb 12494.81  14986.50  $2491.69 
  12/31/97  206 Eastman Ko 12475.88  14819.13  $2343.25 
  12/31/97  276 Philip Mor 12489.00  11074.50 -$1414.50 
  
  
                              CASH    $415.96 
                             TOTAL  $56775.65