History Of The Dow
Welcome & Introduction

(BK) The Dow, 1884 - 1886

(BK) The Dow Today

Charles Dow: Wall Street Revolutionary

DT: A Framework For The Averages

The Dow Jones Averages

Dow Mechanics

The Dow Dividend Approach

The Dow is 100 years old! So just what the heck is it and how can an individual investor use it? This collection will showcase a series of articles answering just those questions as part of AOL Personal Finance's celebration of the Dow reach 100.

Welcome & Introduction

This Special Section focuses on the history of the Dow Jones Industrial Average as well as the best way to use the awkward device. We will be releasing a series of daily articles over the next two weeks that give a detailed history of the average and explain the basics of the Dow Dividend Approach.

We bring together the best of the Motley Fool and AOL's Personal Finance area to deliver this collection to you.

Glossary

FW = FoolWire (a Fool News product)
FT = FoolTake (a Fool's opinion)
BK = Background article

Enjoy,

Randy Befumo (MF Templar), a Fool

FOOL BACKGROUND*

The Dow, 1884 - 1886

(FOOL EQUITY RESEARCH)
by Randy Befumo (MF Templar), a Fool

July 3, 1884 (Customer's Afternoon Letter, ten railroads and one industrial)

Chicago & North Western
D. L. & W.
Lake Shore
New York Central
St. Paul
Northern Pacific pfd.
Union Pacific
Missouri Pacific
Louisville & Nashville
Pacific Mail
Western Union (only non-railroad)

February 16, 1885 (12 railroads and two industrials)

Central Pacific
Central RR of New Jersey
Chicago Milwaukee & St. Paul
Chicago North Western
Delaware & Hudson Canal
Delaware Lackawanna & Western
Louisville & Nashville
Missouri Pacific
New York Central
Union Pacific
Pacific Mail Steamship
Western Union

January 2, 1886 (12 railroads and two industrials)

Chicago Milwaukee & St. Paul
Chicago North Western
Delaware & Hudson Canal
Delaware Lackawanna & Western
Lake Shore Railroad
Louisville & Nashville
Missouri Pacific
Northern Pacific pfd.
New York Central
Union Pacific
Pacific Mail Steamship
Western Union

April 2, 1894

American Sugar
Chicago Milwaukee & St. Paul
Chicago Burlington & Quincy
Chicago Rock Island & Pacific
Chicago North Western
Delaware & Hudson Canal
Delaware Lackawanna & Western
Louisville & Nashville
Missouri Pacific
Northern Pacific pfd.
Union Pacific
Western Union

May 26, 1896 (all industrials)

American Cotton Oil
American Sugar
American Tobacco
Chicago Gas
Distilling & Cattle Feeding
General Electric
Laclede Gas
National Lead
North American
Tennessee Coal & Iron
U.S. Leather pfd.
U.S. Rubber

* A Fool Background article is meant to explain and elucidate an investment, economic, or business term or concept.

Transmitted: 5/3/96

FOOL BACKGROUND*

The Dow Today

(FOOL EQUITY RESEARCH)
by Randy Befumo (MF Templar), a Fool

The Current Make-up of the Dow Jones Industrial Average

AT&T Corp. (NYSE: T)
Allied Signal (NYSE: ALD)
Aluminum Company of America, or Alcoa (NYSE: AA)
American Express (NYSE: AXP)
Bethlehem Steel (NYSE: BS)
Boeing (NYSE: BA)
Caterpillar (NYSE: CATE)
Chevron (NYSE: CHV)
Coca Cola (NYSE: KO)
Disney (NYSE: DIS)
DuPont ei de Nemours (NYSE: DD)
Eastman Kodak (NYSE: EK)
Exxon (NYSE: XON)
General Electric (NYSE: GE)
General Motor (NYSE: GM)
Goodyear (NYSE:GT)
IBM (NYSE: IBM)
International Paper (NYSE: IP)
McDonald (NYSE: MCD)
Merck (NYSE: MRK)
Minnesota Mining Manufacturing (NYSE: MMM)
Morgan JP (NYSE: JPM)
Phillip Morris (NYSE: MO)
Proctor & Gamble (NYSE: PG)
Sears (NYSE: S)
Texaco (NYSE: TEX)
Union Carbide (NYSE: UK)
United Technologies (NYSE: UTX)
Westinghouse (NYSE: WX)
Woolworth (NYSE: Z)

The Current Make-up of the Dow Jones Transportation Average

AMR Corp. (NYSE: AMR)
Airborne Freight (NYSE: ABF)
Alaska Air (NYSE: ALK)
American President (NYSE: APS)
Burlington Northern (NYSE: BNI)
CSX Corp. (NYSE: CSX)
Caliber Systems (NYSE: CBB)
Conrail (NYSE: CRR)
Consolidated Freightways (NYSE: CNF)
Delta Air (NYSE: DAL)
Federal Express (NYSE: FDX)
Illinois Central (NYSE: IC)
Norfolk Southern (NYSE: NSC)
Ryder Systems (NYSE: R)
Southwest Air (NYSE: LUV)
UAL Corp. (NYSE: UAL)
Union Pacific (NYSE: UNP)
USAir Group (NYSE: U)
XTRA Corp. (NYSE: XTR)
Yellow Corp. (NASDAQ: YELL)

* A Fool Background article is meant to explain and elucidate an investment, economic, or business term or concept.

Transmitted: 5/3/96

Charles Dow:
Wall Street Revolutionary

Charles Dow came from humble origins, yet managed to transform the world of investing more than any high-powered money manager or investment banker. He wasn't born in the center of cosmopolitan New York and he wasn't a financial child prodigy found scanning the stock tables for price/earnings ratios at a tender age. Dow was born in 1851 on a farm and worked odd, menial labor jobs from the age of six to help support his family after the death of his father. Although writing appealed to Dow, he did not finish secondary school. In spite of this, he managed to get a job at the age of 18 as a reporter for the "Springfield Daily Republican." The Republican was a newspaper of national repute edited by newspaper giant Samuel Bowles, reknowned for establishing the credentials of aspiring journalists.

Dow continued his reporting work at another prominent newspaper, "The Providence Journal". He worked under the leadership of George W. Danielson, another outstanding editor of the day. Through a series of articles Dow established himself as an insightful historian of the local scene with a keen interest in financial affairs. From tracing the corporate transactions of steamship companies to discussing investments in Newport real estate, Dow found that financial reporting not only matched his interests but also suited his temperament.

After a move to New York and a stint with the Kiernan News Agency in 1882, he started Dow Jones & Co. with two partners, Edward Jones and Charles Bergstresser. They set to work immediately, first publishing a two-page daily called the Customer's Afternoon Letter in early 1883. By 1889, the Customer's Afternoon Letter evolved into the Wall Street Journal.

The Customer's Afternoon Letter was nothing short of revolutionary. In Dow's time, consolidated stock tables published every day did not exist. Information about a company's balance sheet was rarely published, with management attempting to hide and obscure the full value of their company for fear of takeover. The Letter not only reported consolidated stock tables, but also made public quarterly and annual information regarding company financials -- something that only insiders had available to them before this. Dow's publication leveled the playing field between the Wall Street elite and the individual investor. It would not be until the Securities Act of 1934 that companies would be required to file 10-Ks and 10-Qs that all investors could look at. So, for more than fifty years, the only place for the individual investor to get the straight poop on company financials was the Wall Street Journal.

In line with founding the first daily publication dedicated to the financial world, Dow Jones & Co. were the first to see the need for an index that could be used to gauge the activity of the New York Stock Exchange as a whole. The first Dow Jones Index, the precursor of the Dow Jones Industrial Average, included ten railroad stocks and Western Union from the handful of companies traded on the New York Stock Exchange. At that time, railroad stocks represented a key growth industry and, as such, were the only shares traded in large volume on the NYSE. That is why they were chosen. The initial Average was simply the price of all eleven stocks added up and divided by the number of companies.

Although Charles Dow never wrote anything that claimed he invented the Average and, in fact, never really wrote anything at all about his thoughts on investing, the record left by his contemporaries clearly shows that he was the idea man behind all of Dow Jones & Co.'s endeavors, while his partners managed the employees and kept the books. Dow, never content with his invention, continued to tweak the the list of companies making up his Average until his death in 1902. Charles Dow left behind the first average, a barometer for the general pressure of the "market." The investment world would be a very different place without the kind of reporting and financial disclosure pioneered in the Wall Street Journal or the notion of an average used to measure where the broader market was at any given point.

Randy Befumo (MF Templar), a Fool
Alex Schay (FW Games), a Fool

Transmitted: 5/3/96

DT: A Framework For The Averages

Charles Dow had one goal in mind when he created the Dow Jones Averages: to measure the market as a whole rather than simply focusing on individual stocks. He wanted to make these Averages the foundation of a comprehensive theory that could be used to explain and predict general market movements. Dow was originally credited with creating the first general market average in July of 1884, although he later modified this and began to publish separate Industrial and Railroad Averages on May 26, 1896. These Averages are the foundation of Dow Theory.

What we know today as Dow Theory was actually posthumously attributed to Mr. Dow by S.A. Nelson in his 1902 book, "The ABC of Stock Speculation". Dow never wrote a book on investments and confined his opinions to anonymous editorials in the Wall Street Journal. In Nelson's book, he clearly identified Dow as the intellectual force behind the Wall Street Journal, and in fact lamented that Dow never published a comprehensive text on "speculation". Nelson believed Dow's position at the center of Wall Street would have uniquely qualified him to write such a tome. Dow held a seat on the New York Stock Exchange for a year and used his time to cultivate numerous contacts among the leading investors of his day.

In "The ABC of Stock Speculation", the chapter headings of chapters five through nineteen carry an asterisk with the accompanying footnote explaining this reference mark in two words -- "Dow's Theory". As George Bishop notes, "Hardly an auspicious beginning for an appellation that has endured in the language of the market to the present day."

Dow Theory contains nascent forms of both fundamental and technical analysis, as neither discipline had been fully developed during the infancy of the stock market. Many terms that are now considered crucial to technical analysis first appeared in Dow's Wall Street Journal editorials -- including the idea of primary, secondary, and tertiary "trends" lasting for different fixed durations. The irony here, of course, is that Dow was an avowed fundamentalist, propagating the notion that prices followed earnings and that balance sheets should be made public for all investors to see. Companies in this bygone era were not too keen on allowing investors to see what sort of cash, debt, or receivables they were carrying on their balance sheets.

Graham and Dodd in Security Analysis further credit Dow with the notion of accumulation and distribution, stating Dow believed "when movements of several weeks or longer are confined ... to a range of 5 per cent, a 'line' is said to have been formed suggesting either accumulation or distribution." One general market average was not enough for Dow to confirm accumulation or distribution. Dow wanted to have two averages "break out above the line simultaneously" to confirm accumulation, or "break out below the line simultaneously" to show distribution. It was this innovation that lead Dow to break his first general average of 1884 into two distinct averages.

Dow's Theory called for the creation of an Industrial Average and a Railroad (Transportation) Average as a way to confirm the general direction of the market. Using these Averages, one would be able to tell where the market was going if movements in the two separate Averages "confirmed" one another. If both Averages were moving upward and had broken through their previous highs, the stock market was headed even higher. If both Averages have broken through prior lows, then the market was going down. If only one Average had broken a previous high or low, or if both Averages were flopping around and not doing much of anything, no conclusion on general market direction could be reached, and it was assumed that the market would go sideways.

The reasoning behind this part of Dow Theory is actually common sense, even if it does depend heavily on investor psychology. Charles Dow thought that if industrial stocks were rising, then investors must think that they have great potential. If all of the railroad stocks are rising, then things must be looking pretty good for them. But, since railroads made their money by toting the goods of industrial concerns around the country, you could not say that the prospects for one group were good until the prospects for the other group were good. In other words, the industrials could not thrive without increasing the business of railroads, and the railroads could not increase their earnings unless they were being deluged by shipment orders from industrial manufacturers.

Today, the tight links between the Industrial and Railroad/Transportation averages have dissipated. The Dow Industrials include many companies whose goods and services, for the most part, do not need to be shipped (e.g., AT&T, J.P. Morgan, and Walt Disney). Also, many Transportation Average stocks, like AMR Inc. (the parent company of American Airlines) or USAir, now focus on commercial travel, which is not directly tied to industrial production.

The impetus for revising the Industrial and Raiload Averages, as opposed staying with one general Dow average, was that they would be inextricably linked together. There is supposed to be a direct correlation between them in order for Dow's Theory to work. Although many modern purveyors have turned his thought into technical gobbledegook, the simple fact is that if Dow were alive today, he probably would reject any attempt to predict the market with his averages as they are now constituted. Dow Theory, as least as far as Dow crafted it to be, has absolutely no contemporary relevance. However, Dow's Averages live on and remain a fixture in the investment world, with the Industrials having become a measure for the market as a whole.

[For those interested in learning more about Dow Theory, the most comprehensive text on the subject is Bishop's "Charles H. Dow & The Dow Theory," available at most libraries.]

Randy Befumo (MF Templar), a Fool
Alex Schay (FW Games), a Fool

Transmitted: 5/8/96

The Dow Jones Averages

It was not until the spring of 1896 that Dow had developed his ideas to the point where he completely removed the railroad issues from his general market Average and created two separate Averages --the Industrials and the Railroads. Now the Wall Street Journal reported an independent Railroad Average as well as an Average composed entirely of industrial and natural resource concerns -- the Dow Jones Industrial Average (DJIA). Although they first appeared on May 26, 1896, the Industrials were not reported in the Wall Street Journal on a regular basis until October 7th of the same year. Their starting point on October 7th? A mere 40.94 (a fraction of the near-6,000 level where the DJIA sits as of this writing).

Early on, the Industrials were a dynamic Average, changing composition on an almost monthly basis. Because the Dow Jones Industrial Average was supposed to represent the current business environment, Charles Dow actively sought to include the key industries of his time -- sugar, spirits, leather, cordage, tobacco, gas, lead, rubber, coal, iron, and electrical products. This is a far cry from today's Index, dominated by retailing, oil, technology, pharmaceuticals, and entertainment companies.

The original Industrial Average included names like American Cotton Oil, American Sugar, Distilling & Cattle Feeding, Laclede Gas, National Lead, and U.S. Rubber. (To see the full list, check out the article called The Dow, 1884-1886.) Today's Average has companies like American Express, Walt Disney, Merck, and United Technologies filling its ranks. (To see the full list, check out the article called The Dow Today.)

The only company on the original list of Industrials that has managed to endure is General Electric -- although it has been removed from the Index twice (obviously, only to be added back again later). The original Railroad Average was replaced by the more generalized Transportation Average after a number of trucking, airline, and air-shipping concerns were added to it in 1970. These changes included the first Dow stocks to come from the NASDAQ Composite instead of just from the New York Stock Exchange -- first Roadway Services and now Yellow Corp. (NASDAQ: YELL).

The last development was the fifteen-stock Dow Jones Utilities Average, making its first appearance in 1929.

Despite public perception to the contrary, the Dow Averages have continued to change in recent years -- and these alterations are far from accidental. A new component has been added, on average, every three years since the inception of the Average. Although originally it was Charles Dow himself who changed the Averages, today Dow Jones & Co. employs a "Keeper of the Dow" to perform this function. The current Keeper of the Dow is a man named John Prestbo.

The Keeper of the Dow leads the crack team of Dow Jones editors who oversee any shifts in the composition of the Averages. The Keeper's job is to see that periodic adjustments are made to ensure that the Averages continue to reflect the current business climate, as well as to compensate for mergers and bankruptcies involving Dow stocks. This function has maintained Charles Dow's original commitment to ensure that the mix of companies on the Averages remain analogous to the broader market. In that the current batch of Dow stocks are involved in 61 of the 96 industries that Dow Jones & Co. has developed independent indices for, it appears that they have been successful.

A number of factors are considered when choosing a company to represent a specific industry in the Dow. Is the company a leader? How long has it been around? Does it treat its shareholders well? What is its reputation in the industry? Dow companies have to be leaders in a particular industry or sector. The Dow has traditionally been made up of corporate giants, massive companies whose shares have been publicly traded for decades. Although companies like Sears or IBM might appear outdated compared to the Wal-Marts and Microsofts of the world, the mere fact that Sears and IBM have been multi-billion-dollar companies for more than 80 years suggests an incredible staying power that their juvenile competition has yet to demonstrate. Although sometimes the presence of companies like Woolworth on the Index might make it appear antiquated, many investors are too quick to judge -- in this instance forgetting that Woolworth, which owns Foot Locker among other growing retail properties, is more than just its old core business of discount retail stores.

An example of the logic used to maintain the weighting of the Dow is illustrated by the changes that were made in 1985, after Dow component General Foods was bought-out by tobacco giant Philip Morris. The sudden addition of Philip Morris to the Average upset the industry weighting by doubling the number of tobacco companies (American Brands, formerly American Tobacco was already there). As a result, the Keeper of the Dow decided to drop American Brands entirely and add McDonald's to the Industrial Average in order to better represent the restaurant industry. The most recent spate of changes was made in the early '80s, when Walt Disney, J. P. Morgan, and Merck found their way onto the Average.

As far as bankruptcies, in its 100-year history, the only company that has fallen off of the Dow Industrial Average due to financial difficulties is the John Manville company, which was caught in a wave of litigation relating to its premiere fire-retardant product -- asbestos. Chrysler's run-in with red ink, that was eventually resolved by a bail-out from the U.S. government, was probably responsible for its deletion in the early '80s; although the company never did, in fact, go bankrupt. The only other high-profile bankruptcy was Texaco, after the attempted acquisition of Getty Oil resulted a major fine due to a breach of contract. Even Exxon's Valdez disaster and Union Carbide's Bopahl tragedy were just minor inconveniences by comparison.

Although these additions and deletions to the Dow Averages might appear to be only cosmetic, they have an impact that few can fully appreciate without exhaustively researching the topic. For instance, in 1939 American Telephone & Telegraph (AT&T) was substituted for International Business Machines (IBM). If this substitution had not been made, the Dow would have broken 1000 in 1961, instead of 1972, and would be considerably higher than it is today. IBM was only returned to the Dow in 1979, making one wonder if another milestone, the sacred 2000-point barrier, might have been penetrated in the mid-70s instead of the mid-80s if that substitution had not occurred.

Randy Befumo (MF Templar), a Fool
Alex Schay (FW Games), a Fool

Transmitted: 5/8/96

Dow Mechanics

There are currently 30 stocks listed on the Dow Jones Industrial Average, 20 in the Dow Jones Transportation Average, and 15 in the Dow Jones Utility Average (first reporting in 1929).

The Dow Jones Industrial Average only started with 11 stocks in 1884, but has gradually grown to its current 30-stock roster over the past 100 years with three big jumps: in 1885 the Average was increased to 12 stocks; 1916 saw the expansion of the Average from 12 to 20 stocks; and, in 1928, the final move from 20 to 30 stocks was made. One can find the current companies that make up the Dow Jones Industrial Average in an article called "The Dow Today" in this "100 Years of the Dow" collection. Although it is easy to find out what companies are currently on the various Dow Averages, the actual mechanics for computing the Averages are much less transparent.

When Dow created his first eleven-stock Average, he simply divided the total of all the prices by eleven (the number of stocks on the Average) to get his result. Living in the days before frequent stock splits and stock dividends, Dow did not foresee events that would make the divisor change. As markets matured and companies began to try to keep the price of their shares within certain parameters, stock splits became a common tool to keep the price per share at a reasonable level. Until the implementation of the Dow Divisor, how Dow Jones would account for any splits was to multiply the stock price by the number of shares into which each share was split. Unless they did this, a two-for-one split in one of the stocks that made up the Dow would have caused a significant drop in the Average that was not the result of any fundamental change. For example, if General Electric had split 2-for-1 at some point in the past, one would multiply the current price of General Electric by two before figuring out what the Dow had closed at for the day.

Under this policy, the Average simply reflected the results of what a simple buy and hold strategy would have attained -- effectively neutralizing the effects of stock splits. However, stocks that split their shares numerous times would come to have more and more power over the daily moves of the Dow, because their small daily movements would be multiplied to account for numerous splits. This distorted the Average by making it "split-weighted" (allowing companies who split their shares more frequently to have a disproportionate control over the Average). To correct this, the editors of Dow Jones developed the Dow Divisor -- a single number that took into account the splits for each individual stock.

The Dow was first computed using the Dow Divisor on September 10, 1928. Norman Fosback describes how the Dow Divisor works in "Stock Market Logic":

"Assume that the prices of the 30 stocks summed to $3,000. Then the 30-stock average price would be $3,000 divided by 30, or 100.00. If one of the thirty stocks was quoted at $200, but then split two-for-one so that its price fell to $100, the sum of prices would be only $2,900. To maintain the Average at its actual level of 100.00, the divisor of the Average is systematically altered. Since $2,900 divided by 100.00 equals 29, the new divisor is set at 29, down from 30, in effect preserving the average price at $100 ($2,900 divided by 29 still equals 100.00)."

Dow Jones currently adjusts the Dow Divisor if any event effects the Dow Jones Industrial Average by 5.0 or more points. Stock splits and stock dividends alone are not the only forces that work on the Dow Jones Industrial Average -- stock dividends actually have an effect as well. When a stock pays a dividend, the "specialist" who facilitates trades in the stock at the exchange deducts the amount of the dividend, rounded to the nearest 1/8th, from the price of the stock. For example, if General Electric was trading at $50 and was scheduled to pay a $1 quarterly dividend on June 1st, General Electric would trade "ex-dividend" on June 2nd at only $49 a share and shareholders of General Electric would have the stock ($49) and the dividend ($1), for a total of $50 worth of stock and dividends. Large, one-time cash or stock dividends and spin-offs of subsidiaries can move the Average a heck of a lot more than 5.0 points, so the Divisor is constantly being adjusted to account for all of this.

This Divisor approach worked well for the first few decades but, in recent years, the Divisor has started to become very small. In 1986, the Dow Divisor fell below 1.0 for the first time -- effectively becoming the "Dow Multiplier" since, to divide by a fraction, you invert it and multiply (resulting in a larger number).

With the Dow Divisor for the Industrials at about 0.346 as of this writing, the prices of the stocks on the Average are effectively tripled when the Dow is computed. This creates a situation where even a fractional movement in the price of the Dow Industrial stocks (say up or down by 1/2 a point) results in relatively large movements in the Dow Average reported (for a 1/2-point move in the stocks, it would translate to a 43-point move in the DJIA).

If by some chance more than a few of the Dow Industrials trade ex-dividend on the same day, the difference between the last evening's close and that morning's open can be as much as 20 points. Since only two of the 30 stocks currently do not pay dividends, this happens more frequently than most would imagine. (Anyone interested in looking up the current Dow Divisor for the Industrials or any other Dow Average can find it every day in the Wall Street Journal's Money and Investing section, on page C3 in the Dow Jones Averages area.)

As a result of the way the Dow is computed, the Average has effectively become a "price-weighted" measure of the market. The Divisor simply measures the sum of the day's changes -- there is nothing in it to account for the fact that a $1 change in a $15 stock is, percentage-wise, greater than a $1 change in a $100 stock. Because it measures all net changes in the same way, in effect there is a weighting system that tilts movements in the Averages toward the higher-priced stocks. A $1 move up or down in a $100 stock is a commonplace event, whereas a $1 change in a $15 stock is more rare. Given that, the Divisor does not correct for the relative scarcity of the large changes in "value" represented by a $1 move in a $15 stock. In effect, the higher-priced stocks affect the Average more since they are prone to make more $1 movements even though, on a percentage or valuation basis, these moves are smaller than an equivalent $1 move in a $10 stock. Although this might make one question whether the Index is truly representative of the New York Stock Exchange (the original intent) or the broader market (its de-facto contemporary function), it helps us better understand the day-to-day movements in the Dow.

Randy Befumo (MF Templar), a Fool
Alex Schay (FW Games), a Fool

Transmitted: 5/8/96

The Dow Dividend Approach

In spite of generally loathing market timing, the Motley Fool pays careful attention to the Dow Jones Industrial Average. Is that because we think it is the best indicator for the overall market? Nope. We actually think that is just a side-effect of the brand name that Dow Jones & Co. has built using the Average, turning it into a household word. We like the Dow because of something we call the Dow Dividend Approach. In fact, we like it so much that we have made it a cornerstone of Foolish investing.

The premier approach used by Foolish investors to produce market-beating returns is the Dow Dividend Approach. The Dow Dividend Approach achieves this status in Fooldom because it is one of the easiest ways to outperform the major market averages ever discovered. Since 1961, the average return of the Dow Dividend Approach has clocked in ahead of the average return generated by the Dow Jones Industrial Average, as well as the S&P 500. The elementary strategy has become so popular that the Motley Fool has devoted an entire area to it -- called the "Dow Area" -- complete with a daily recap of the stocks' performance, written by our own MF Dowman (Robert Sheard).

The Dow Dividend Approach, although it has many variations, is so straightforward that establishing a single "inventor" or "discoverer" is almost impossible. Much like the written word or the wheel, Dow Dividend Approach has simply "always been there" during the recorded history of investing. The foremost spokesman for the strategy, however, is Michael O'Higgins -- whose 1991 book "Beating the Dow" remains a classic in the field. The more recent effort by Knowles and Petty called "The Dividend Investor" is perhaps more thorough in its analysis, but lacks the charm of O'Higgins effort, warts and all.

There are five main variations of the "Dow Dividend Approach" that have been proposed in "Beating the Dow," "The Dividend Investor," and as a result of Ann Coleman's (MF Numbers) analysis of the O'Higgins data online in the Motley Fool. Although a myriad of other alternatives exist, these five variations are the ones that most people in Fooldom pay attention to. The numbers related to these five approaches have been exhaustively back-tested to 1961 by Randy Befumo (MF Templar). For all Fools who want to monkey around with the numbers, Randy's research spreadsheets are available for purchase through FoolMart. Other strategies, as they emerge, will no doubt be examined thoroughly in the Dow Area, under the guidance of the Dow aficionados who haunt that special realm.

All five strategies use the same basic method, with minute variations, to cull a group of one, five, or ten chosen stocks from the thirty Dow stocks. There is a spreadsheet in the Electronic Fool (keyword: ELF) that contains the thirty Dow stocks, which you can use to input the data below. (If you want to use the spreadsheet, skip number one below).

1. Go to any copy of the Motley Fool, the Wall Street Journal or Investor's Business Daily and find the graph of the Dow Jones Industrial Average. Somewhere on this graph will be a list of the thirty current Dow stocks. Write this list down on a piece of paper.

2. Next, look up each stock in the New York Stock Exchange tables and write down its dividend yield and its last price. You could also just type the symbol into America Online's Quotes and Portfolios screen to get the same numbers.

3. Circle the ten stocks with the highest dividend yields. Rank these ten stocks from 1 to 10 according to the share price -- where #1 is the stock with the lowest share price of the group, and #10 is the stock with the highest share price in the group.

4. Scratch out the remaining twenty stocks.

After this exercise, you will be left with the ten Dow stocks used in all five of the main Dow Dividend Approach strategies. These ten stocks are called the Dow Dividend Approach 10, or more irreverently the "Big Ten," depending on who is talking about them. The "Big Ten" variation of the Dow Dividend Approach would continue as follows:

5. Purchase the ten stocks remaining.

6. Hold them for a period of one year after purchase.

7. On the anniversary date, simply repeat steps one through four again, sell any stocks that do not remain on the list and use the proceeds to buy any stocks that are new to the list.

It really is that simple. But this simple approach, from the beginning of 1961 through December 1st, 1995, would have given you a geometric average annual return of 14.57% per year, or a 11671.93% total return. The thirty stocks that make up the Dow Jones Industrial Average returned, on average, 11.39% per year for a 4356.20% total return over the same period. Given this, the "Big Ten" seems to be a superior, "no-brainer" approach to beating the market. Essentially, you buy the ten top-yielding stocks on the Dow Jones Industrial Average every year; and then readjust once a year to include any stocks whose yields have increased and eject any companies whose yields have decreased. The other four strategies are simply variations on this main approach.

The Low-Price Five, Flying Five, or Dow Dividend Approach Five was popularized by Michael O'Higgins, and simply involves an additional cut of the ten highest yielding Dow stocks. To use the Dow Dividend Approach Five, you simply buy the five lowest-priced stocks from your list of the ten highest yielders. You hold them for one year and then readjust your portfolio annually, buying any new stocks that pop up on the low-price high-yield list with the proceeds from selling the stocks that drop off. This approach would have garnered you a 16.03% average annual return since 1961, or a 18209.76% total return.

The High Yield Five was popularized by Knowles and Petty. With this approach, you buy the five highest yielding Dow stocks, ignoring all the others. For this approach, your average annual return would have been 15.13% since 1961, for a total return of 13843.77%. By focusing on the 5 highest yielding issues, you could have generated slightly better returns than buying the entire top ten list. However, this approach, as you will see when we break out the numbers, is a little more volatile.

The PPP and the UPP

The Penultimate Profit Potential (PPP) is an O'Higgins invention, pure and simple. It is called the Penultimate Profit Potential because it is always right below what O'Higgins implicitly calls the Ultimate Profit Potential (UPP). The UPP is the lowest-priced stock of the ten highest-yielding Dow stocks. It may not necessarily have the highest yield of the "Big Ten" or the lowest price of the Dow 30. It is simply the lowest priced of the "Big Ten." The PPP is the second-lowest priced of the "Big Ten." The reasons that these distinctions are relevant is because O'Higgins discovered that, for the period he measured (1973 to 1991), the PPP returned an average arithmetic return of 24.41% annually, or a 6245.49% total return for the period. When measured against the average annual returns of the Dow Dividend Ten (14.45%), the Dow Dividend Five (15.73%) and the Dow Jones Industrial Average (11.14%) for the same 1973 to 1991 period, the PPP looked pretty good. The UPP, by comparison, looked downright awful, having only managed to return 12.80% per year from 1973 to 1991 for a total return of only 513.87%. O'Higgins' explanation of this phenomenon was that the UPP was simply a terrible stock, a company really beaten down by some bad goings on, whereas the PPP represented more of a value. Ironically, the UPP still manages to beat the broader market.

If you examine the returns of the PPP and the UPP Foolishly, the UPP still remains a terrible stock for some reason. From 1961, the PPP average annual returns hangs in at 16.72% per year for a total return of 22383.42% and the UPP return flops around at 11.17% per year for a total return of 4068.67%, failing to beat even the returns of the Dow 30. The UPP does, however, manage to beat the returns of the 20 non-Beating-the-Dow stocks, which have a mere 9.66% average annual return or a total return of only 2523.57%. Although the data at this point supports the case that the UPP is an underperformer, I believe that the explanation for this is simply that a few extreme results in both positions biases the overall numbers due to the relatively small number of data points. For 35 years, it only takes two or three really bad years to make any average return suck for the UPP. I believe that as you extend the time period measured, the returns of each of the Dow Dividend Approach stocks, no matter what its position in the price ranking, will "revert toward the mean," meaning that the total returns in each position will not be substantially different. However, some disagree with this assertion and like to throw out the UPP.

The last variation of Dow Dividend Approach avoids the UPP, doubling up on the PPP instead. It was developed from MF Numbers compilation of the O'Higgins data in late 1994 by a team of Foolish researchers including MF Bo Jest and tjwalsh, among many others. This approach, which originally had the unwieldy name of 2,2,3,4,5, has been given the appellation of "The Foolish Four" by Editor Tom Gardner. It was developed as a result of back-testing the performance of each stock in the "Big Ten," ranked in order of price. It was discovered that the historical data suggested the best return was achieved by skipping the UPP altogether, buying a double helping of the PPP, and then buying the stocks in positions three, four and five. The average annual return of this approach was 16.91% since 1961, for a total return of 23715.31%. Although you could quibble with the rationale that undergirds this approach, for now it appears that the Foolish Four is numerically superior to the other Dow Dividend Approach methodologies.

Randy Befumo (MF Templar), a Fool
Alex Schay (FW Games), a Fool

Transmitted: 5/8/96

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