Catch a Dow Rising Star
We saw last week that companies added to the Dow have done extraordinarily well as a group for the five or 10 years after they've been included. One very simple strategy, dubbed the Dow Rising Star 4 (DRS 4), incorporates these observations. Backtesting DRS 4 shows that it has easily outpaced both the Dow and the S&P 500 for the past 20 years.
By Ethan Haskel (TMF Cormend)
October 11, 2000
For the last two weeks, I've been examining the performance of stocks that were newcomers to the Dow average -- what I've called the "Dow Rising Stars." We've seen that, as a group, these Rising Star stocks have more than doubled the Dow average when held for either five or 10 years after they've been chosen to join the Dow. Today we'll describe one very simple strategy that might capitalize on these observations.
One way to take advantage of these Dow Rising Stars is simply to buy any company when it joins the Dow and hold it for either five or 10 years. As we saw, that strategy would have paid off handsomely since the late 1970s. On average, these companies returned a total of 154% when held for five years, compared to 69% for the Dow. Holding these companies for 10 years also did well, returning 474% vs. 223% for the Dow. But trying to implement such a strategy can get messy. For instance, currently you'd be holding 11 stocks if you had bought every Dow newcomer and held each for 10 years.
We can simplify such a strategy by just buying the four or five stocks of those Dow companies that are the newest members of the Dow at any given time. If there are more new stocks than you want to buy, select the newest ones first and break any ties (lately the Dow has been adding three or four stocks at a time) by selecting the stocks with the best return for the previous year. Once you've got your four or five stocks, simply keep these same stocks until the Dow changes composition (rebalancing them each year so that the investment in each stock stays more or less the same). Lather, rinse, repeat.
To account for a scenario that the Dow composition may be very static in the future (one that I believe is quite unlikely), we'll add one more rule, a sunset clause: After 10 years, newcomers become oldtimers and are removed from the strategy. In such an unlikely scenario, the strategy may contain fewer stocks than usual.
I'll call this the Dow Rising Star (DRS) strategy, and I've backtested it since 1980. The DRS 4 chooses the newest four Dow stocks, and the DRS 5 the newest five. As I've noted previously, until 1976 there weren't any changes in Dow stocks since 1959. In 1976, 3M <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: MMM)") else Response.Write("(NYSE: MMM)") end if %> was added and in 1979 IBM <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: IBM)") else Response.Write("(NYSE: IBM)") end if %> and Merck <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: MRK)") else Response.Write("(NYSE: MRK)") end if %> were added. I don't feel comfortable with a one-stock strategy, so the strategy was only tested from 1980 on. For the first three years, both the DRS 4 and DRS 5 portfolios would have held just three stocks, and for the next three years they both would have held four.
Here are the compound annual growth rates (CAGR) since 1980, using a January starting date:
CAGR (%)
DRS 4 26.4
DRS 5 23.2
Dow 17.3
S&P 500 17.7
F4 23.2
The DRS 4 strategy in particular has performed quite admirably over the past 20 years, outpacing even the Foolish Four (F4). The DRS returns have been remarkably consistent, too. DRS 4 has outpaced the S&P 500 for 17 of 20 years, while DRS 5 did the same for 16 of these 20 years.
Unlike the F4, the DRS strategies haven't been laggards over the past few years. Even as the Dow as a group has struggled compared to the S&P 500, our Rising Stars have shined. Here are the results for these strategies for the past five years, from 1995-1999:
CAGR (%)
DRS 4 29.2
DRS 5 24.8
Dow 13.8
S&P 500 20.2
F4 16.3
Another potential advantage of the DRS strategies is the low turnover, which minimizes capital gains taxes, trading costs, and portfolio upkeep. The DRS strategies only change stocks when the Dow announces a composition change, which has occurred only a few times per decade recently.
The annual turnover rate for the DRS 4 and DRS 5 strategies has been only 23% and 17%, respectively, for portfolios from 1981-2000, compared to rates of about 50% for the F4 and Beating the S&P (BSP), and anywhere from 100% to over 1000% for some of the Workshop screens. Thus, on average, a DRS 4 portfolio would change about one stock a year, compared with two stocks for a F4 portfolio. The way the stocks for DRS are chosen means that most years you wouldn't be substituting any stocks, while some years you might change most, if not all, of your portfolio.
So, should we all dump the Foolish Four or Beating the S&P strategies and substitute DRS instead? Not necessarily. Next week I'll highlight some of the caveats about using such a strategy, give a few more details, and try to analyze it Foolishly. But for those whose interest has been piqued, the current DRS 4 stocks (from the 1999 change) are Home Depot <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: HD)") else Response.Write("(NYSE: HD)") end if %>, Intel <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: INTC)") else Response.Write("(Nasdaq: INTC)") end if %>, Microsoft <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: MSFT)") else Response.Write("(Nasdaq: MSFT)") end if %>, and SBC Communications <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: SBC)") else Response.Write("(NYSE: SBC)") end if %>. Add the best-performing stock this year from the previous switch, Citigroup <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: C)") else Response.Write("(NYSE: C)") end if %>, and you've got the DRS 5.
Beating the S&P year-to-date returns
(as of 10-10-00):
Bank One <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: ONE)") else Response.Write("(NYSE: ONE)") end if %> +10.9%
PepsiCo <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: PEP)") else Response.Write("(NYSE: PEP)") end if %> +35.6%
Ford Motor Co. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: F)") else Response.Write("(NYSE: F)") end if %> -11.0%*
Bank of America <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BAC)") else Response.Write("(NYSE: BAC)") end if %> +0.0%
Fannie Mae <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: FNM)") else Response.Write("(NYSE: FNM)") end if %> +10.3%
Beating the S&P +9.1%
Standard & Poor's 500 Index -5.7%
*Includes Visteon <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: VC)") else Response.Write("(NYSE: VC)") end if %> spin-off
Compound Annual Growth Rate from 1-2-87:
Beating the S&P +23.5%
S&P 500 +16.4%
$10,000 invested on 1-2-87 now equals:
Beating the S&P $183,100
S&P 500 $80,600
