A reader wrote in asking whether we think that the Foolish Four is still a good investment. We aren't as sure of that as we used to be, but there are good reasons for including it as part of a balanced portfolio, if you have patience.
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Dorothy Stroppa, president of the SLIC Investment Club, wrote:
"Our investment club would like a quick reading on your opinion of the Foolish 4. We saw many remarks on the discussion board and the F4 is down 13% this year, but it is unclear what to do regarding the Foolish Four, i.e., is the philosophy changing? Has the new expanded database yielded more insights? Any advice for our club wishing to invest in it?"
Dorothy,
I'm glad you asked, because those questions are on everyone's mind these days. You asked for my opinion, so I will give it, but please, don't take it too seriously. There are a lot of opinions about the Foolish Four, free for the asking on our discussion board. There is no reason why mine should be given any more weight that that of others who have studied the strategy thoroughly, and the only opinion that really counts is yours. (Cliche, anyone?) If you don't have an opinion yet, don't invest until you have developed one.
It's annoying, but there are no easy answers. (I know you know that.) The Foolish Four is a mechanical investing strategy. It follows certain rules that, if applied in the past, would have picked stocks that, on average, outperformed the market. Deciding to use a mechanical strategy is not nearly as simple as we used to think.
When you look at the numbers, all of the yield-based Dow strategies (Beating the Dow, the Foolish Four, and about 20 other strategies we follow on our Dow Dividend Spreadsheet) have either lost to or barely matched the market over the last three years. Prior to that, they beat it by a wide margin. It's one thing to recommend a strategy that has been doubling the market, and quite another to recommend one that is barely matching or losing to the market.
It's a fact that none of the yield-based Dow strategies have done well recently. This could mean that the original idea of using yield, and particularly yield and price, was based on a faulty premise, and that their amazing performance prior to 1997 was a statistical aberration, so naturally they won't work anymore. There are a number of people who believe that, some of them quite passionately.
Here's where my opinion comes in: I don't think that the performance prior to 1997 was just due to chance. Of course, I may have a vested interest in believing that, just like a friend of mine who doesn't believe that cigarettes cause cancer. He works for Brown and Williamson. He thinks he's quite objective about the issue, too. I like to think that I am objective, but you should be aware that I may not be when you evaluate my opinion.
Monday, I will try to summarize the points on both sides of this controversy. But today let's stick with your specific questions. While I don't think that the performance of the high-yield/low-price strategies prior to 1997 was just due to chance, the question remains: Should you invest in them today? Obviously the strategy isn't doing well this year. And, people who bought during the last half of last year when Sears <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: S)") else Response.Write("(NYSE: S)") end if %> and Goodyear Tire <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: GT)") else Response.Write("(NYSE: GT)") end if %> were on the list are doing even worse.
I know you want my opinion about investing now, but I don't really have one. I look back at the history of the strategy and see other years when the market did badly and the Foolish Four did even worse. When the market rebounded, the Foolish Four rebounded even higher. And, there are stretches where the Foolish Four didn't beat the market or barely beat it.
The same thing could be happening again, but there is no way to tell. We could also be seeing a long-term shift away from the importance of dividends. If high yield is not attractive any more due to the higher taxes on dividends compared to capital gains, that could easily be enough to wound or kill strategies that rely on high yield. On the other hand, if enough high-growth companies with no earnings go bust, dividends, and the undervalued Old Economy companies that pay them, could start looking very attractive again.
On the other, other hand, the tech companies could transform the world and put the Old Economy stocks into Buggy-Whip Manufacturing Land.
This is the painful part of investing, and it is, perhaps, even more painful when you are relying on a formula to pick your stocks. At least if you investigate a company thoroughly, you can investigate the future for its industry and products. A mechanical strategy doesn't do that. You substitute faith in the strategy for faith in the company. What we have now could be called a crisis of faith.
I am hoping that the new CRSP database will provide some answers -- if not about the future, then at least about the strategy's validity in the past. If it was never valid, we can all pack up and go home. I don't expect to see that, but some other pretty smart people do. We don't have any answers just yet, because there were some technical problems with the first batch of CRSP data. They've been corrected, and I hope to have some very preliminary results soon, but I don't know how much help that will be to anyone. It will probably be quite some time before the community has run the statistical tests they think need to be run, debated their significance, and reached, hopefully, a consensus of sorts.
But, even if irrefutable evidence for the legitimacy of the Foolish Four is produced conclusively (sure!), that still won't tell us that the strategy will work going forward. Back in 1996, the evidence for Beating the Dow (the original high-yield/low-price strategy) was pretty good, considering the data available at the time. It had worked 18 years prior to publication, and doubled the market for five years after. Five years of "post-discovery" results are persuasive, but not predictive.
My feeling about the strategy is that it is most worthwhile as an investment in value stocks, perhaps to balance out a portfolio that has a lot of high-flying growth stocks. Value stocks are completely out of favor right now, and traditionally that has been the time to buy them.
But, to be comfortable with this kind of investment, you really need a long-term perspective. If you aren't prepared to give the strategy time to work, and the market time to move from the growth-stock part of the cycle to the value-stock part, I don't think you will be happy with it.
Here is some comfort, but it may be a bit chilly. If the Foolish Four is a product of a random statistical fluke and has no validity, one would expect that, over time, it would match the Dow. In other words, if it simply picks stocks at random, over time, a random mix of stocks should perform about as well as the pool of stocks they were picked from. This doesn't mean that your bottom line would match the market, by the way. The strategy will generate more commissions and taxes than an index investment, but it does limit the potential downside. Despite its bad performance this year, I don't think anyone is arguing that the strategy might seriously underperform the market.
Well, that's a long answer to a short e-mail. It's not likely to be a very satisfactory answer, I know, but that's where we stand now.
Fool on and prosper!