<THE FOOLISH FOUR>

The Dividends in the DDA
by Chris Rugaber
(TMF RFK)

Alexandria, VA. (September 15, 1998) -- One of the many questions surrounding a system like the Dow Dividend Approach and Foolish Four (DDA/FF) is whether it will ever "not work," either because too many people are following it or some other such change. In fact, one of the principal early advocates for the DDA, Michael O'Higgins, who formalized and popularized the DDA in his 1991 book Beating the Dow, has apparently renounced it himself, as discussed in previous articles in this space.

Yet the DDA/FF does not depend on the approval of individual authors. It is based on a simple, transparent idea: that high-yielding blue chip stocks are likely to be at a low point in their business cycles, but given their size and resources will probably recover and even grow. Nevertheless, this formula does rest on one element that is subject to change --dividends. The DDA/FF approach depends in part on Dow companies paying consistent or increasing dividends over the years regardless of their earnings.

As most of you may know, dividends are paid out by most -- usually, all -- the Dow stocks. This dividend, when divided by the company's share price, gives us the dividend yield. This yield is the percentage return you'd earn on the stock if the share price remained flat. If a company's earnings are reduced, and its share price declines as a result but its dividend remains roughly the same, then the dividend yield increases. It thus becomes a high-yielding stock, relative to the other Dow stocks.

If a corporation were to decide, however, to reduce its dividend because of its reduced earnings, then the yield would not increase as the price declined. Such a company would be less likely to be included in the "Dogs of the Dow," even though it might have the characteristics of one.

As the apostate O'Higgins points out in his book, in the U.K., for example, companies are more likely to do just that: they adjust their dividends as their earnings change. (Though our colleagues over at Fool UK don't seem to have any problems with this -- their Beating the FTSE seems to work, as well... hmmm). At any rate, in the United States, the Dow blue chips are less likely to do so -- they see maintaining their dividends as a point of pride. As O'Higgins writes, "In the United States the dividend is a sacred cow. A company would do almost anything to avoid lowering or suspending a dividend." So, the DDA/FF works in part because U.S. companies have historically maintained their dividend payments through most up-and-down periods.

A second key aspect of dividends is that, as O'Higgins also notes in his book, "Historically, dividends have accounted for 40 to 50 percent of the total return on the Dow stocks as a group, so this cherished continuity of dividends is of more than passing importance to Dow stockholders." These two characteristics of Dow stock dividends -- their ability to signal blue chip stocks that are in a downswing, and their contribution to the DDA/Fool Four's total return -- make them worth monitoring.

Since O'Higgins's book was published, many observers have pointed out that dividend yields for Standard & Poor's 500 Index stocks as a whole are near historic lows, primarily as a result of increasing stock prices. Is this also happening to Dow stocks, thereby potentially reducing returns from the Dow approach? Secondly, are Dow companies continuing to pay stable dividends, or are they reducing dividends when earnings decline?

Using our trusty Dow Dividend Spreadsheet, available in FoolMart, the short answer to the first question appears to be no. While average yields of the Dow stocks fluctuate depending on bull and bear markets, generally they seem to be holding up. In the past five years, from 1993-97, the Dow 30 stocks have averaged a yield of 3.72%; from 1961-65, the average was 3.47%. Yields were higher in the five-year period of 1971-75, which included the early '70s bear market, with the Dow 30 averaging a yield of 4.64%. So it may take a bear market to fully answer this question. After all, in 1997 the Dow 30 yield was the lowest it has been since our spreadsheet began backtesting the DDA in 1961 -- 2.22%.

The second question is harder to answer. Given the overall consistency of the yields, one can assume the same is true about dividends themselves, and therefore companies are not immediately reducing dividends upon earnings declines. As pointed out by O'Higgins, the paying of consistent dividends is as much a traditional thing as anything else, and it would require a noticeable attitudinal change, spread out over many years, before anyone could say that there has been a major shift in this area.

Both these aspects of dividends bear watching in the coming years, especially if we have a sustained market downturn anytime soon. New companies, such as Wal-Mart and Hewlett-Packard, are paying lower dividends than some of the old-timers. Any Fools out there with something to add to my speculations, please head over to the message boards!

Current Dow Order | 1998 Dow Returns

What Happened to Robert Sheard?

09/15/98 Close

Stock Change Last -------------------- UK - 5/16 38.63 IP +1 15/16 44.31 MO + 15/16 44.88 EK +1 1/2 81.81

Day Month Year FOOL-4 +1.96% 6.69% 8.08% DJIA +0.99% 6.44% 1.47% S&P 500 +0.77% 8.37% 6.93% NASDAQ +0.74% 11.93% 6.86% Rec'd # Security In At Now Change 12/31/97 206 Eastman Ko 60.56 81.81 35.09% 12/31/97 289 Int'l Pape 43.13 44.31 2.75% 12/31/97 276 Philip Mor 45.25 44.88 -0.83% 12/31/97 291 Union Carb 42.94 38.63 -10.04% Rec'd # Security In At Value Change 12/31/97 206 Eastman Ko 12475.88 16853.38 $4377.50 12/31/97 289 Int'l Pape 12463.13 12806.31 $343.19 12/31/97 276 Philip Mor 12489.00 12385.50 -$103.50 12/31/97 291 Union Carb 12494.81 11239.88 -$1254.94 CASH $754.73 TOTAL $54039.79