Why Does It Work?
And a note from Japan

by Ann Coleman

Alexandria, VA (November 30, 1998) -- I had an interesting e-mail from Japan over the long weekend. Self-professed Dedicated Fool, Dwaine Palmer, wrote to request that we spend a bit more time elucidating why these strategies work. Enough with the statistics already!

His point is an excellent one: "If you evaluate 1024 investment strategies to pick a market beater (as Fools all over the world are currently doing), odds are you should find one that beats the market 11 years in a row. (Even the Foolish Four and the RP4 haven't done that.) What have you found? A strategy that has as much chance to beat the market next year as a strategy that has lost to the market for the last 11 years.

"We need something more than just empirical evaluations of strategies. For example, if after 11 years of study, you found an investment broker who beat the market 11 years in a row, AND you also found out that he was Alan Greenspan's part time hairdresser and hypnotic therapist, THEN you have found a real market beater.

"Simple empirical/statistical analysis of the broker/strategy is meaningless without truly understanding why the results are there (or at least having a pretty good idea). It also gives us good signs to watch for to see that the predictor is still effective. When Alan Greenspan no longer needs a hairdresser, then your predictor may quickly lose effectiveness."

Dwaine is right on the money -- so today we take another look at why the Foolish Four works.

All of our homegrown variations on the basic Dogs of the Dow strategy look at two factors: high yield and low price. The Foolish Four strategies use a dual screen --screen the 30 Dow Stocks for the 10 highest yielders, then screen those ten for low price. The RP variation uses a more sophisticated way to look at yield and price. Instead of ignoring any stock that doesn't make the High Yield 10 list, it looks at the ratio between yield and price. Thus a stock that might be 12th or 14th on the yield list could get picked by the RP system if its price was low enough. More about that later.

First, yield. When a very stable, major company (like the Dow companies) has a high dividend yield, what does it mean? Well, yield is the dividend divided by the price. So a high yield (high relative to other stocks of the Dow) means that the price is low relative to the dividend. The dividend is "on sale."

Suppose you are a fund manager running a growth and income fund. For the income part you need to buy dividends. So, would you rather buy $1 worth of dividends for $50 or for $30? A fifty dollar stock paying $1 annually has a 2% yield. (1/50). A thirty dollar stock paying a one dollar dividend has a 3.3% yield. This is the basic attraction of high yield stocks. After a while, given no major disasters, the demand for their dividend tends to move the price up back to where the dividend is more in line with other, comparable stocks.

Now, high yields can also be a danger sign. When the price drops too low, the market is saying, in effect, "You can't give this dividend away!" Usually that happens when a company is in major financial trouble and is desperately keeping up its dividend payment even though earnings aren't covering the dividend. When you are borrowing money to keep up the dividend payment, that doesn't bode well for future earnings. That's what happened to Woolworth a few years ago. It was losing money but still paying a 4% dividend. Wall Street wasn't "buying" it, though, and in 1994 the price plunged.

Most Dow companies, which are chosen for their financial stability, don't get themselves into that kind of situation, though, although it is not uncommon among some smaller high yielding companies. With Dow stocks, the low price is usually a result of bad short-term outlook or some kind of temporary setback, not a situation that threatens to destroy the company. Not every high yield stock turns around, but enough of them head north again to give the High Yield 10 strategy a 3 percentage point advantage over the Dow as a whole. The High Yield 5 strategy, which picks just the 5 highest yielding stocks, confirms this -- over the last 25 years, it beat the Dow by an average of 4 percentage points per year.

The Foolish Four looks at both yield AND price. But, really, why should price matter? Yield already levels the playing field. Yield tells you what each dollar's worth of dividends will cost you, regardless of the stock price. Price, however, has an impact on how much and how quickly a stock's price moves. This, of course is an academic finding, which means it is true when you look at large numbers of stocks, but there are also many exceptions. In general, lower-priced stocks tend to be more volatile than higher-priced stocks. Bear in mind that volatility just means that the price changes a lot -- both drops and rises count. However, when a lower-priced stock is also paying a nice dividend, there is an excellent chance that the direction of the volatility is likely to be UP. So buying a lower-priced high yielding stock is a way to hitch a ride on that volatility when it is going in the right direction.

The RP variation uses a more sophisticated formula to do the same thing our old "sort by yield, sort by price" formula does. It uses the ratio between a stock's yield and its price, but not the straight price. As William Proctor notes in The Templeton Touch, "Stock price fluctuations are proportional to the square root of the price." Bob Price found that dividing the yield by the square root of the price produced a ratio that was even better at predicting good stocks than the Foolish Four was.

If you don't understand the theory behind the RP, it can sound like one of Dwaine Palmer's lucky strategies -- try a bunch of formulas and pick the one that works best. (And, actually, that was pretty much the way Bob Price discovered it.) We may be unwittingly contributing to that impression by publishing the formula as "yield squared divided by price." Square root signs are hard to handle in text, and "yield squared divided by price" gives a ratio that is proportional to "yield divided by the square root of price." In this case, the theoretical explanation came after the formula. Sometimes that's the way great discoveries are made.

For my money, I'll take Sir John Templeton over Alan Greenspan's hairdresser any day.

Fool on and prosper!

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Current Dow Order | 1998 Dow Returns

11/30/98 Close
Stock  Change   Last
UK   -1  3/16   44.75
IP    +  23/73  43.44
MO   -2  5/27   55.94
EK   -2  3/25   72.63
                   Day   Month    Year
        FOOL-4   -2.22%   2.91%  14.32%
        DJIA     -2.32%   6.10%  15.28%
        S&P 500  -2.40%   5.92%  19.92%
        NASDAQ   -3.32%  10.06%  24.15%

    Rec'd   #  Security     In At       Now    Change

 12/31/97  276 Philip Mor    45.25     55.94    23.62%
 12/31/97  206 Eastman Ko    60.56     72.63    19.93%
 12/31/97  291 Union Carb    42.94     44.75     4.22%
 12/31/97  289 Int'l Pape    43.13     43.44     0.73%

    Rec'd   #  Security     In At     Value    Change

 12/31/97  276 Philip Mor 12489.00  15439.44  $2950.44
 12/31/97  206 Eastman Ko 12475.88  14961.78  $2485.91
 12/31/97  291 Union Carb 12494.81  13022.25   $527.44
 12/31/97  289 Int'l Pape 12463.13  12554.16    $91.03

                Dividends  $1092.81
                   TOTAL  $57070.44