Quest for Fool Four Answers
Recent testing has shown that it's probable the Foolish Four strategy won't dramatically outperform in the future like the backtested returns seemed to originally indicate. These observations spell trouble for the Beating the S&P strategy, which was developed to be analogous to the Dow high-yield strategies. But, in investing as well as medicine, the quest for better answers continues, powered by the scientific method.
By Ethan Haskel (TMF Cormend)
December 20, 2000
As some readers are aware, financial journalism is not my day job. By day, and often into the wee hours of the morning, I'm a cardiologist. But sometimes the lessons learned from one profession can't help but spill over into the other.
About six years ago, when I first became director of the coronary care unit of my hospital, most patients who were having a heart attack were being treated with a solution of magnesium by vein, an electrolyte that had been shown in experiments to prevent rhythm abnormalities and protect heart muscle. The history of this treatment dates back over 40 years when a doctor reported that, of 64 consecutive patients treated, only one died in the following four to six weeks -- a remarkable record, since mortality rates for comparable patients were 20-50% in the 1950s.
Although the results of this initial study were replicated shortly thereafter, these findings were mostly forgotten, until a placebo-controlled study in 1986 on 276 randomized patients reported a mortality improvement of 70%. A number of other studies seemed to confirm these results, including a 1992 randomized trial of over 2,300 patients that reported a 24% drop in mortality. All from a simple electrolyte solution that cost only a few pennies.
Thus spawned an era when magnesium became a treatment staple for heart attack patients, along with aspirin and other, so-called "clot-buster" drugs. However, the enthusiasm for magnesium treatment stopped abruptly in 1998 when the largest controlled trial of all, one that included over 58,000 patients, found that patients who were treated with magnesium had, if anything, a slightly higher risk of dying. As a result, the American Heart Association guidelines no longer recommend magnesium for these patients.
I like to think of the Foolish Four and Beating the S&P (BSP) as the magnesium of mechanical investing.
Like magnesium therapy for heart attacks, the impetus for the Foolish Four and BSP started with a set of uncontrolled observations reported in the early 1990s, with the publishing of Beating the Dow by Michael O'Higgins. O'Higgins used a backtested sample of 18.5 years of data to show that, in retrospect, a handful of five low-priced, high-dividend Dow stocks beat the pants off the Dow.
Fools ran with this Dow data. In attempts to improve the results, multiple variations were devised, including one of dropping the lowest-priced stock of the high yielders, and devising a variant -- the latest official Foolish Four -- in which the ratio of the yield to the square root of the stock price was used. The backtesting was expanded to a full 39 years, with better backtested results than even the original O'Higgins formula.
Then James O'Shaughnessey's What Works on Wall Street was published in 1996, which confirmed, with 43 years of backtesting, that "Large, well known market-leading companies are much better investments when they have a value characteristic like low PE ratio or low price-to-cash flow ratio, but the best criterion is dividend yield" (Italics mine). Multimillion dollar Unit Investment Trusts -- aimed to take advantage of the Beating the Dow formula -- sprouted, and Fools fretted over the potential that over-popularity of the strategy would limit future results.
Here's where BSP comes in. In 1995, I created a variation of Beating the Dow, in which very large stocks that were not included in the Dow were used to create a portfolio chosen to mimic the then-popular variation of the Foolish Four in which the high-yield, low-price formula was used, but the lowest-priced stock was dropped. Announced officially in a Fribble, BSP was then backtested to 1987, the first year that my alternative stock database was available, with excellent results.
Unlike the Foolish Four, such a model portfolio performed quite well in the period after discovery, beating the S&P 500 since 1995, with a CAGR of 24.8% vs. 20.9% for the S&P. Elan Caspi later backtested a slightly different variation of BSP, and again the strategy was found to outperform the S&P 500. Another variant, which excluded stocks that had split within the past year (since they were not truly beaten-down companies) has performed even better, and is the Official BSP variant. (I know, I'm guilty of data mining here, but we were a relatively naive crew when this variant was proposed.)
Fast forward to 2000. The Foolish Four has been put to the ultimate test, now 50 years of data. As reported by Ann Coleman, the results are certainly not encouraging. More disappointing to BSP investors, though, is that, when the Dow stocks are removed from the database, the results look worse, rather than better.
Since the BSP backtest was so limited, the foundation for BSP was the strength of the Dow strategies. Now recent testing has shown the foundation is shaky, to say the least. Thus, I don't expect BSP to outperform the S&P 500 by significant margins in the future.
The collapse of the Foolish Four and Beating the Dow variants is dramatic, nearly as dramatic as the decline in the use of magnesium to treat heart attacks. Both strategies were initially based on feasible hypotheses, created by well-meaning individuals. Both were put to rigorous tests, but eventually the most rigorous tests found these strategies wanting.
What we're witnessing, Fools, is the scientific method at work. The scientific method's four basic steps include:
- Making an observation.
- Formulating a hypothesis to explain the observation.
- Using the hypothesis to predict other events that were outside the initial observations.
- Performing valid scientific studies to test these predictions.
Countless reasonable theories have been rejected over the centuries after scientific observations failed to prove the hypotheses. The apparent failure of the Foolish Four is just one in a string of many failed hypotheses. Every so often one of these seemingly ridiculous observations will hit pay dirt, whether it's the discovery of penicillin, or Goodyear's process for vulcanizing rubber. That's how we as a civilization improve, constantly testing new ideas until we get it right.
But our story may not be quite over yet, either medically or financially. Despite the apparent finality of the 58,000 patient magnesium study, many have criticized the results. Critics of this large study point out that the dose used in the study was higher than that used for the other studies that showed a beneficial effect, and the drug was given much later during a heart attack than was customary. New, better designed studies are under way. Magnesium may yet rise again.
And I'm not yet totally convinced that there might not be valuable information still to be gained by rummaging through the ashes of the Foolish Four or BSP. I still think there's value in balancing out a mechanical growth portfolio with a mechanical value portfolio. While there are many promising mechanical growth strategies brewing in the Workshop, there's now a gaping hole for good value strategies that's begging to be filled.
This year provides a dramatic example of how value strategies can be useful at times. A January BSP portfolio happens to be trouncing the market this year, up 13.8% versus a decline of 11.1% for the S&P 500, 38.3% for the Nasdaq, and more than 25% for many of the growth-oriented Workshop portfolios. My personal BSP stocks, bought in mid-July, are about even, compared with the S&P's loss of about 11%. Certainly these short-term results for BSP prove nothing about its long-term prospects, but they've been my anchor in this year's storm.
I've yet to look at the CRSP study in detail. It would be interesting to see how the individual stocks were chosen, how the sectors were established, and the validity of the returns. The CRSP study, unlike BSP, included all of the largest capitalized stocks, even if they didn't pay dividends. It didn't compare returns to the S&P 500 directly, but rather with the other top stocks in the larger group of 30 (although the returns were said to be virtually identical to the S&P 500 over the 50-year span). The CRSP data used the RP formula rather than the original method where stocks are first ranked by yield, then price.
It's clear that the data did not backtest the version of BSP we're now using, which might be a formidable chore, but possibly valuable. It's quite possible, even likely, that this might not make a significant difference in the conclusions. Right now I feel as if I've read the results and conclusions of a scientific paper, without looking at the methods section. Medical students have always been taught that the most important part of any scientific study is often those details in the methods section.
Call me a Fool, or a fool, but I'm still out there, searching for a better way.
Beating the S&P year-to-date returns
(as of 12-19-00):
Bank One <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: ONE)") else Response.Write("(NYSE: ONE)") end if %> ����������+15.7%
PepsiCo <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: PEP)") else Response.Write("(NYSE: PEP)") end if %> �����������+41.1%
Ford Motor Co. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: F)") else Response.Write("(NYSE: F)") end if %> ������-16.3%*
Bank of America <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BAC)") else Response.Write("(NYSE: BAC)") end if %> �� �-7.8%
Fannie Mae <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: FNM)") else Response.Write("(NYSE: FNM)") end if %> ��������+36.3%
Beating the S&P ������������� �+13.8%
Standard & Poor's 500 Index ���-11.1%
*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 �������� ������+24.8%
S&P 500 ��������������� �������+15.8%
$10,000 invested on 1-2-87 now equals:
Beating the S&P ������� �����$191,100
S&P 500 ��������������� ������$76,100
