<THE FOOLISH FOUR>

Foolish Four Report
by Robert Sheard

LEXINGTON, KY. (April 22, 1998) -- With all of the research we've done on the Dow Approaches over the last few years, too often we fall into the trap of looking for every last ounce of performance in the historical numbers with slight variations of the basic approaches. While this is understandable, it's not always the best way to invest because each new slight variation will send readers into tizzies about what the best method is. This is supposed to be low-maintenance and simple, isn't it?

Sometimes the variations with the best returns take on more and more risk until you have investors trying to pick the single best Dow stock (or best two, whatever).

Let's step back a minute. By all accounts, the Unemotional Value two-stock approach (buying just the first two of the Foolish Four stocks) has done well historically. Since 1971 (on an end-of-year 12-month cycle), it has returned 25.9% a year. But could you sleep easily with all your money parked in two stocks? I certainly couldn't and would never recommend the UV2 as an approach to be used for an entire portfolio. I only tested it to demystify the supposed predominance of Michael O'Higgins's PPP stock (the #2, or Penultimate Profit Prospect), not to put it forth as a viable investment approach.

Even four stocks alone is too concentrated a portfolio for my sleep-factor. Once you get up to a level of about $5,000 or $10,000, I feel you have to begin diversifying into other stocks as well to avoid putting too much emphasis on any one stock.

But does that mean you have to give up those stellar returns? Not really. First of all, I think by supplementing the Foolish Four with other stocks, you can actually increase your returns and reduce your risk. The Foolish Four strategy is a great core -- no doubt about it -- but other approaches can be even more powerful and a combination of growth and value strategies is a nice way to go.

And if you're anxious to squeeze every drop of performance out of your holdings, using a conservative level of margin on a more diverse portfolio might generate similar returns without resorting to a very concentrated and inherently riskier portfolio strategy. Using something conservative like 20% margin leverage with the Foolish Four is likely to give you roughly the same returns as the straight UV2, without plowing everything into two stocks.

Or even more stable might be a slightly leveraged High Yield 10, which provides much more stability in that the risks are spread across ten stocks, but by using a reasonably safe level of margin, you can boost the long-term returns two to four percentage points a year. And as for margin calls, as long as you keep the margin level conservative (20% to 25%) of your invested total, you'd have to suffer a massive meltdown worse than anything we've seen in our database's history before you'd be subject to a margin call.

For example, if you're using 20% margin and your broker's minimum equity requirement is 30%, your entire portfolio would have to drop approximately 70% before you'd get a margin call. Let's use dollar amounts. If you have $80,000 and borrow $20,000 on margin, you're using 20% margin. At this point your equity is 80% of the total. To trigger a margin call, your equity has to slip below your broker's limit -- let's say 30%. Since you'll still owe your broker $20,000 (plus interest) no matter what your stocks do, any loss comes straight out of your equity.

Let's say your portfolio drops 50%, to a value of $50,000. You still owe $20,000 and your equity is $30,000, or 60% of the total -- no margin call. Let's say it drops 60%, down to $40,000. Half of that is yours and half is owed to the broker -- still no margin call. Let's say it drops 70%. Now you're looking at the margin call, because of the $30,000 that's left, only one-third is yours. So if your broker's equity requirement is 35%, you'll get a call. If it's 30%, you're going to get one soon if it drops any more.

But snap back to the world of Dow Approach investing for a minute. If the Dow Approach sheds 70%, I'm not being flippant in suggesting that a 20% margin amount is going to be the least of our worries. Margin is always a double-edged sword. It exaggerates your portfolio movements whatever direction they take. But based on the long-term history of the Dow Approaches, it's one prudent way of staying in a more diversified portfolio of relatively stable stocks to manage risk and boost long-term returns.

As long as interest rates remain low (currently around 7% for margin loans at many brokers), leverage, when used modestly, is a weapon to include in your arsenal. Like any other weapon, though, if you use it carelessly (maxing out your leverage at 50%, for example, or using it on top of a very risky strategy), it's probably going to go off in your hand. Be reasonable in both your expectations and your tools to accomplish those expectations, and Fool on!

Current Dow Order | 1998 Dow Returns

[Robert Sheard is the author of The Unemotional Investor (Simon & Schuster, 1998) available now at Amazon.com and soon at your local bookseller.]

TODAY'S NUMBERS

Stock Change Last -------------------- UK - 5/16 50.94 IP - 3/4 54.44 MO - 5/8 38.81 EK +1 5/8 73.56

Day Month Year FOOL-4 -0.26% 6.43% 13.67% DJIA -0.09% 4.28% 16.04% S&P 500 +0.35% 2.59% 16.47% NASDAQ +0.72% 4.46% 22.11% Rec'd # Security In At Now Change 12/31/97 289 Int'l Pape 43.13 54.44 26.23% 12/31/97 206 Eastman Ko 60.56 73.56 21.47% 12/31/97 291 Union Carb 42.94 50.94 18.63% 12/31/97 276 Philip Mor 45.25 38.81 -14.23% Rec'd # Security In At Value Change 12/31/97 289 Int'l Pape 12463.13 15732.44 $3269.31 12/31/97 206 Eastman Ko 12475.88 15153.88 $2678.00 12/31/97 291 Union Carb 12494.81 14822.81 $2328.00 12/31/97 276 Philip Mor 12489.00 10712.25 -$1776.75 CASH $415.96 TOTAL $56837.34