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The whole Foolish Four strategy is based on dividends. Dividends are the key to identifying the stocks that are undervalued. Now, three of the new Dow stocks looked like they were unlikely ever to be picked by the formula no matter how beaten down their prices got, simply because the dividends were so small or nonexistent.
The Dow has had stocks that paid very low dividends, or none at all, before this, but usually those were stocks that had cut their dividends because they were in financial trouble. Only in the '90s have we seen Dow stocks that were healthy, growing companies that chose not to pay out a lot of their earnings in dividends, but to instead reinvest that money in growing the company.
This isn't something that started with the last change. But that last change focused many of us on what was actually happening.
It is very difficult to tease out all the different strands in this lowered-dividend mess. Dividends in general have been dropping as interest rates have dropped. That's to be expected. They have also been dropping as the average "payout ratio" (the percentage of earnings that is paid out in dividends) has declined due to a shift in investor preferences. These days a company doesn't necessarily perceive a high dividend as something that marks them as a good company to invest in.
Investors used to see the dividend as "income," something to live on in retirement, but now it is often seen as a tax hog. Dividends are taxed at "regular" income tax rates, but capital gains are taxed at a much lower rate. All other things being equal, investors have begun to think, "Why not sell a few shares if you need cash to live on and pay less in taxes?"
Why not indeed.
For the record, I don't think that dividends are going away anytime soon. If Congress decided to give people a tax break to encourage savings and investing, it would likely create a lower tax bracket for interest and dividends earned, which would change perceptions dramatically. Besides, old habits change slowly. There are still plenty of investors who demand dividends, not to mention mutual funds whose stated investment strategy is to invest in high-dividend stocks.
Still, all of these changes make one wonder about the Foolish Four strategy's continued viability. The problem isn't that dividends are lower, per se. The formula works fine on lower dividends, and a relatively high dividend yield is still a pretty good sign of an undervalued company even if, in dollars, the yield is quite low. The problem is that the pool of potential Foolish Four stocks is shrinking. In the '70s and '80s the range of yields was smaller and almost any stock that had been sold off could theoretically qualify for the Foolish Four.
But today, many of those low-yield stocks are the "growth stocks" of the Dow. It's hard to imagine a company like Microsoft, or even McDonalds or Wal-Mart, ever qualifying for the Foolish Four. All told, there are nine stocks on the Dow with a yield of less than 1%.
What concerns me is that the nature of the Dow is changing in a way that restricts the number of stocks that can be considered for the Foolish Four. There is more emphasis on growth and less on dividends. I don't think that the strategy is less effective, but the pond we're fishing in may be too small for it now.
The problem is that this is a data-driven strategy. What I "think" really isn't very important. We need data. We are working on getting that data, but it's not here yet, and it will take a while to analyze it once we get it.
In the meantime, we plan to run our demonstration portfolio for next year using the same strategy that we used this year. I'm not inclined to toss out something that has a track record of outstanding performance until we have hard data that demonstrates a better option. But for the sake of folks who are interested in at least seeing how a combined Dow/BSP strategy would work, I will be creating a new list at Today's Stock Lists called the Dow/BSP Blend. It will contain all of the stocks from each list and will rank all 57 or so by RP. I am not recommending using it, because it is not a tested strategy, but it will be there for anyone who wants to take a look.
There are other strategies that have been developed here and in the Foolish Workshop that are not Dow-based. They've been backtested for 12 years and have impressive records over that time. I will go over those tomorrow.
Sigh. Really, it would have been much more convenient if those Dow Dudes had made their changes last spring.
For those of you who are counting, yes, this article was scheduled to run tomorrow, but it grew -- so it's running today AND tomorrow. Ethan Haskel, our BSP guy, generously agreed to give up today's spot (who doesn't want time off at this time of year?) so that we could discuss this whole New Dow question thoroughly.
Not that I'm promising answers... I do hope to lay out all of the questions and many of the alternatives for you, though.
Finally, if you're interested in participating on this week's Motley Fool Radio show, see this link and contact Mac Greer at [email protected].
Fool on and prosper!
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