Value Investing, Part 2
The Foolish Four Way, continued

by Ann Coleman (TMF

Reston, VA (March 3, 1999) -- Value. That's what we want. Like people who get in line at 7 a.m. for the store openings on December 26th, we want to get the most for our investment money. (I've never actually seen that phenomenon -- I've always been asleep -- but I've heard about it.)

Stocks don't normally get red tags when they go on sale. Value investors have to first figure out what the stock is worth then compare that to its selling price to find out if the stock is "on sale." The Foolish Four offers busy investors a way to identify value stocks without all the hassle of deconstructing annual reports and trying to arrive at some kind of intrinsic stock value.

Now, this shorthand method works only because we are using it on a small subset of very large, very strong companies, those chosen to represent US industry by the Dow Jones & Company. Or, as we've seen recently, by other subsets, such as the Standard & Poor's 500 Index.

Within this very limited universe of very strong companies, some companies will be occasionally out-of-favor with the investment community. Wall Street expresses its disdain for a company by selling it off, causing the price to drop lower and lower as more and more people decide they want nothing to do with that loser. So "out-of-favor" means cheap, but cheap itself is not an indicator of value. Some companies are very rightfully out of favor, due to serious financial problems that may indicate years and years of slow or no growth ahead. They are the lamps that only take bulbs from Albania or the Cashmere sweaters with one sleeve too short.

Maybe the company has run afoul of environmental laws, or been very publicly sued, or suffered a quarter of unexpected reduced earnings. With Wall Street's emphasis on how well your stock holdings do this quarter or, at most, next, such temporary problems can cause investors to desert in droves -- only to return six months or a year later when the temporary danger has passed. (Of course, this desertion-in-droves is what causes the stock to become a bargain. If everyone just decided to wait it out, there would be no particular advantage to these strategies. Maybe we should cool it on preaching the buy-and-hold philosophy. Naah, who listens anyway?)

The Foolish Four, and indeed, all of the Dow Investing strategies, use a very simple indicator to winnow out the bargains from the merely cheap. A bargain, in this context, is a stock that that has been sold off far more than its present circumstances warrant.

The factor that indicates to us that the stock may not be such a disaster is the dividend yield. A company that is not in financial crisis won't cut its dividend just because of some little lawsuit. Nope, that dividend is the nearest thing to sacred that business knows.

Let's digress just a minute to address an important point. We are discussing a general mechanism here that works quite imperfectly. It works well enough to have provided outstanding returns of over 24% per year over the last 25 years. But it certainly does not work in every case. Exceptions abound -- expect nothing less.

OK, back to the general rule. We have a big company that has suffered some kind of temporary setback to which much of the investing community has overreacted. The price has dropped, BUT the company has no reason to drop its dividend because it's not in any kind of financial crisis. When the dividend stays the same and the price drops, the dividend yield (D/P=Y) goes up. Thus a higher yield indicates a lower price. (Of course, it could also indicate a higher dividend, but if the company is not out of favor, the market's natural reaction to a higher dividend is to bid the price up enough so that the yield returns to its former range.)

The Foolish Four compares the stocks of the Dow on the basis of their RP ratios, the ratio between the dividend yield and the square root of price. The relative bargains on that list of 30 stocks are those that have higher RP ratios. There is one exception. We ignore the stock with the highest RP ratio -- too often in the past that one has proven to be beyond bargain status.

Now imagine all those folks who buy stocks for big institutional investors -- the mutual funds and pension funds who buy stocks for their yield as part of their mission. These are not adventurous folks. They are not the ones to buy Exxon (NYSE: XON) just after the Valdez incident. But as time goes by, that higher yield starts to look better and better, and memories of oil-smeared gulls fade. Pretty soon, they can resist the yield no more and the buying picks up. When that happens, the rest of the market notices that the stock is rising again. Whoa, don't want to miss this bandwagon! On they all jump, and pretty soon all is forgiven.

Meanwhile, the Foolish Four investor has used the RP formula to identify the company when it was down and bought in while everyone else was exiting. He waits. He may wait some more. But eventually, that patience pays off.

The key here is that the companies of the Dow are so strong and have such resources at their disposal that disasters that would bring a smaller company to its knees merely cause them to stumble. That's when you want to be ready, and that point is what our RP formula helps you find and take advantage of.

Friday: Could we improve the formula?

Fool on and prosper!

Call Your Boss a Fool.

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Today's Stock Lists | 1998 Dow Returns

03/03/99 Close
Stock  Change   Last
CAT  -   3/16  47.25
JPM  +   3/8   112.44
MMM  +   7/16  74.81
IP   -   1/16  40.31

                   Day   Month    Year   History
        FOOL-4   +0.09%   0.56%   1.58%   3.09%
        DJIA     -0.23%  -0.33%   1.18%   0.78%
        S&P 500  +0.18%  -0.86%   0.19%   0.44%
        NASDAQ   +0.27%  -1.00%   3.31%   4.72%

    Rec'd   #  Security     In At       Now    Change

 12/24/98   24 Caterpillar   43.08     47.25     9.68%
 12/24/98    9 JP Morgan    105.51    112.44     6.57%
 12/24/98   14 3M            73.57     74.81     1.69%
 12/24/98   22 Int'l Paper   43.55     40.31    -7.43%

    Rec'd   #  Security     In At     Value    Change

 12/24/98   24 Caterpillar 1034.00   1134.00   $100.00
 12/24/98    9 JP Morgan    949.62   1011.94    $62.32
 12/24/98   14 3M          1030.00   1047.38    $17.38
 12/24/98   22 Int'l Paper  958.12    886.88   -$71.25

              Dividends Received      $15.04
                             Cash     $28.26
                            TOTAL   $4123.49