<FOOLISH FOUR PORTFOLIO>

Shorting the Dow
And logic traps

by Ann Coleman (TMF [email protected])

Reston, VA (June 14, 1999) -- I've been playing with numbers again -- this time looking at LOW yielding stocks. The idea of shorting the lowest-yielding Dow stocks keeps coming up from time to time, so I decided to take a good look at those low yield guys, and what I found was very interesting.

First, a word or two on shorting. Shorting is a way to profit from a stock when it drops in price instead of when it rises. When you sell a stock short (which you can do just as easily as you can make any other trade), you are instructing your broker to borrow shares of that stock and sell them. The cash from the sale appears in your account. (No, you can't take it out. Your account also carries a debit for the value of the shares.)

Eventually, of course, you have to return the borrowed shares. The shares don't come from specific stockholders, by the way. They come from a pool of shares maintained by brokers just for shorting. Buying shares to return them to the share pool is called "buying to cover."

Imagine that you shorted 100 shares of Philip Morris <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: MO)") else Response.Write("(NYSE: MO)") end if %> last year near when it was selling for $55. You borrowed the shares and sold them for $5,500. That $5,500 sat in your account until today when you decided it was time to "cover." You place an order to close out your short and the broker will buy 100 shares of MO at $42, which costs you $4,200. Those shares are returned to the short pool, clearing your debit, and leaving you with $1,300 in cash in your account. Cool, eh?

Shorting is a valuable technique for sophisticated investors. But it's not for everyone. If you are wrong about the stock.... Say you thought General Motors <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: GM)") else Response.Write("(NYSE: GM)") end if %> was in real trouble last summer during the strike and shorted it. It went from the high forties to the low nineties in just a few months. Now you owe 100 shares of stock that cost 40% more than you received when you sold them short. That's a big owie. (For more on the mechanics and perils of shorting, see our FAQ on Shorting Stocks and #11: Give thought to "shorting" stocks in The 13 Steps to Investing Foolishly.)

Picking a stock to short requires all the time and effort, and then some, of picking stocks that you expect to go up. Naturally, if one could find a nice mechanical system like the Foolish Four for Shorts (now that's a really silly name!), it could be an excellent way to protect your investment in those years when the market heads south. That is a very appealing idea.

Could we develop a way to mechanically pick good shorts? (This just keeps sounding sillier!) Well, I gave it a try. I took a look at the LOWEST yielding Dow stocks. What a surprise! While the Low Yield 20 has a pretty dismal track record, the 5 lowest-yielding stocks have actually done fairly well over the last 10 years. In fact, last year they trounced the high-yielding Dow strategies, rising 47%.

Whoa! Guess you didn't want to short them! Who are these low-yielding stocks? Well, last year they included Wal-Mart <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: WMT)") else Response.Write("(NYSE: WMT)") end if %>, up 105%, and IBM <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: IBM)") else Response.Write("(NYSE: IBM)") end if %>, up 74%. These are the high-growth stocks of the Dow. They pay lower dividends because they are investing in growth and it is paying off.

What does this tell us? Is this a flaw in the whole Foolish Four strategy? Not at all. First of all, it's JUST ONE YEAR. The Foolish Four beat the Low Yield 5, and by a substantial amount, in 32 out of 34 rolling 5-year periods between 1962 and 1998. Don't beat the door down to switch strategies. (However, a bit more investigation into this phenomenon might be justified!)

The one thing that it does tell us is that you can't make assumptions about the converse. If A is true, then the opposite of A should be false. Right? Sorry.
This kind of logical flaw is sometimes hard to detect because it seems so... well, so logical. But knowing that it is almost always true that "when the sun is shining, it isn't raining" doesn't mean that you can assume that it usually is raining when the sun isn't shining.

Fool on and prosper!

Today's Stock Lists | 1999 Dow Returns

One of the latest Fool books is the ultimate guide to Dow Investing and some of its best variations -- order The Foolish Four: How to Crush Your Mutual Funds in 15 Minutes a Year.

(c) Copyright 1999, The Motley Fool. All rights reserved. This material is for personal use only. Republication and redissemination, including posting to news groups, is expressly prohibited without the prior written consent of The Motley Fool.

Today's Stock Lists | 1999 Dow Returns

06/14/99 Close
Stock  Change   Last
--------------------
CAT  +   1/2   59.94
JPM  +   5/16  126.56
MMM  +3  5/16  89.25
IP   +2  3/16  54.44



                  Day    Month   Year   History
         
        FOOL-4   +2.19%   3.53%  25.71%  27.57%
        DJIA     +0.69%   0.03%  15.44%  14.98%
        S&P 500  +0.03%  -0.59%   5.60%   5.85%
        NASDAQ   -2.03%  -2.92%   9.38%  10.88%

    Rec'd   #  Security     In At       Now    Change

 12/24/98   24 Caterpillar   43.08     59.94    39.13%
 12/24/98   22 Int'l Paper   43.55     54.44    25.00%
 12/24/98   14 3M            73.57     89.25    21.31%
 12/24/98    9 JP Morgan    105.51    126.56    19.95%


    Rec'd   #  Security     In At     Value    Change

 12/24/98   24 Caterpillar 1034.00   1438.50   $404.50
 12/24/98   22 Int'l Paper  958.12   1197.63   $239.51
 12/24/98   14 3M          1030.00   1249.50   $219.50
 12/24/98    9 JP Morgan    949.62   1139.06   $189.44

              Dividends Received      $49.99
                             Cash     $28.26
                            TOTAL   $5102.94