Strategy Talk
Picking our portfolio

by Ann Coleman

Alexandria, VA (December 11, 1998) -- Time to talk strategy. Even though our real money portfolio will use a mechanical stock picking strategy, there is still the question of which strategy. All this year we have been following stocks picked by the Foolish Four strategy in our model portfolio, but we have also been talking about a very exciting development, the RP variation.

Our current Foolish Four portfolio selects stocks based on a variation of Michael O'Higgins's Beating the Dow method. It was based on research by Robert Sheard, which showed that O'Higgins's lowest priced stock tended to dramatically underperform the others when it was also the highest yielder. (There is a good reason for that. When a Dow stock gets beaten down in price too much -- the high yield is also an indicator of relatively low price, remember -- it is often because the company is in real, long-term financial trouble.)

The RP variation was developed on the Dow Investing message board. It was published there first by Elan Caspi, but the formula had been independently discovered and sent to Robert Sheard several months earlier by Robert Price. In Fair Foolish Fashion, we credit them both with the discovery.

What they both discovered was that a mathematical formula that combined price and dividend was a better predictor of future stock price than the somewhat clumsy rank-by-yield, rank-by-price method that Michael O'Higgins developed and that we had always used. Not only did it pick better stocks, it was more stable in how it picked them.

The RP variation selects four stocks based on the ratio between price and yield (the same factors that the Foolish Four has always used) -- specifically, the ratio of the yield divided by the square root of the price. (Don't worry, we will go over it in more detail later.) We've been following this variation for a year now, and I've come to the conclusion that not only is it a better indicator of which stocks will do better in the coming year, it is better in every other respect (with one possible exception).

Here's what we have found and published over this past year:

RP portfolios outperform rank-by-yield/rank-by-price portfolios by an average of 2.5% percentage points per year (CAGR = 21.86 for the Foolish 4 vs. 24.62 for the RP variation). That difference didn't pass our test of statistical significance, but it was, as they like to say in statistical circles, "highly suggestive." Better performance is not enough, though. We have other strategies that have even higher returns, but they are one- or two-stock strategies with high risk factors.

RP portfolios are less risky than the portfolios picked by the current method. The backtested RP portfolios have a lower standard deviation than our rank-by-yield/rank-by-price portfolios and, by at least one well-respected risk analysis formula, RP portfolios have much better risk to reward ratio.

In fact, the RP variation beat our rank-by-yield/rank-by-price portfolio in every way I can think of except possibly one, and that depends on how you look at it -- simplicity.

It's the "math issue." One of the things we have loved so much about our Foolish Four is that it is easy to understand. Certainly anyone who wants to keep using it for that very reason is fully justified and will find a model portfolio based on those picks listed here for the foreseeable future. It is one of our basic tenets that you should only invest in something you understand.

But, for my money, the RP variation is a better way to pick our Foolish Four stocks. It is the method we will use on December 23 to determine the stocks that the Foolish Four Portfolio will hold for the next year.

Monday, we will go through several examples of how the RP works, step by step. In the meantime, click on "Today's Stock Lists" below (formerly Current Dow Order) to see the RP in action, and check out how it has performed this year by clicking "1998 Dow Returns."

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Current Dow Order | 1998 Dow Returns

12/11/98 Close
Stock  Change   Last
UK   -   3/4   41.06
IP   -   1/2   40.88
MO   +   9/16  52.88
EK   -   1/8   72.00
                   Day   Month    Year
        FOOL-4   -0.43%  -4.89%   8.56%
        DJIA     -0.22%  -3.23%  11.55%
        S&P 500  +0.12%   0.24%  20.20%
        NASDAQ   +0.66%   4.09%  29.22%

    Rec'd   #  Security     In At       Now    Change

 12/31/97  206 Eastman Ko    60.56     72.00    18.89%
 12/31/97  276 Philip Mor    45.25     52.88    16.85%
 12/31/97  291 Union Carb    42.94     41.06    -4.37%
 12/31/97  289 Int'l Pape    43.13     40.88    -5.22%

    Rec'd   #  Security     In At     Value    Change

 12/31/97  206 Eastman Ko 12475.88  14832.00  $2356.13
 12/31/97  276 Philip Mor 12489.00  14593.50  $2104.50
 12/31/97  291 Union Carb 12494.81  11949.19  -$545.63
 12/31/97  289 Int'l Pape 12463.13  11812.88  -$650.25

               Dividends Paid YTD  $1092.81
                            TOTAL  $54280.37