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A Response to a Response
by Ann Coleman (TMF AnnC@aol.com)
RESTON, VA (July 22, 1999) -- I apologize. I hate to devote another article to this topic when we have so many more interesting things to discuss, like retirement planning and the DuPont/Conoco spin-off, but I'm going to have to bring up that Money Magazine article one more time.
I'm delighted to see an online link to that article now. (Just click the link above to read it.) I tried to find one last Thursday when I wrote the original response, but it wasn't online at that point -- or, at least, I couldn't find it.
Today's column is a response to a second article refuting our rebuttal. I promise this is the last time we get into it here. Mr. Zweig still believes that the Foolish Four doesn't make sense. Which is fine. Everyone's entitled to their own opinion. Copernicus's theory that the earth revolved around the sun didn't make sense to most people until Tycho Brahe made some very careful measurements and Johann Kepler did the math. Not that the Foolish Four is in that league!
In today's article Mr. Zweig wrote: "It's remarkable that when a Fool asks, 'Why do you think the price of a stock has anything to do with its performance?' Ms. Coleman has no answer. Stop and think about this for a moment: How can you possibly advocate an investing technique based largely on low price if you don't know why -- or even whether -- low price affects performance? Considering that the intellectual validity of the Foolish Four "strategy" depends on the answer to this question, it's stunning that Ms. Coleman admits she simply doesn't know."
It may be stunning to see actual honesty, but I hope most of my readers are used to it. However, I did not say that I didn't know. I said I had wondered about it for years. I have seen the claim from academic studies that volatility correlates with the square root of price made, and, while I accepted it at face value at first, I later learned that another study had found that the correlation disappeared when penny stocks were excluded. Hummm, I thought -- we have two conflicting claims. I sure would like to see how this works on a database limited to Dow stocks.
The very fact that the RP formula beats a high-yield strategy is evidence (though not conclusive) that that such a correlation exists, so I haven't been in any particular hurry to push for a confirming study. (Until now, that is!) The only difference between a high-yield strategy and the RP formula is that the RP looks at both yield and the square root of price. When comparing a 5-stock RP strategy with a 5-stock high-yield strategy, the RP strategy beat the HY strategy in 22 of 29 rolling 10-year periods by an average of 1.8% per year. And the numbers get better when you look at 15- and 20-year periods.
Anyone who has read this column frequently knows that I have written many times about how little a stock's price means in isolation. That's another reason why I've wondered about this question. When selecting individual stocks, price by itself is irrelevant. But none of the Dow strategies are based "largely" on price. They use price as a final determinant after first selecting for quality and stability (by using only Dow stocks), then for high yield (of which price is a component), and finally for price on its own. The RP combines those final two steps, but price is still only one factor.
Even though we don't have the definitive answer to the question about how price may affect Dow stock performance, neither does anyone else. The study that will answer the question is not a simple one and, until recently, the data to perform it was not available to us. It will take a while to conduct and check. In the meantime, I don't find the idea as absurd as does Mr. Zweig.
Mr. Zweig continues: "There is indeed academic evidence that small-cap stocks have higher betas; and historically, small-cap stocks have had lower share prices than large-cap stocks. But this relationship can't apply to the Dow; it's not a small-cap index."
I haven't gotten into this in print before because I don't like dealing in opinion and conjecture. I'd rather have numbers to quote. But it is only opinion and conjecture to say that there is no correlation in the absence of evidence for either side.
So here is why I think that there probably is a correlation between price and performance for large-cap stocks. Please note, all of these reasons are speculation and although I think they are probably true, the effect is probably slight. It's only when combined with the value of the high-yield stocks that the "price effect" boosts returns way above the market.
1. Anyone who conducts a strict valuation study and bases their buy decision on that would see that price is not a relevant variable -- but, unfortunately, perhaps, many people, perhaps even fund managers at times, don't buy stocks that way. They look at Hewlett-Packard (NYSE: HWP) at $50 and IBM (NYSE: IBM) at $100 and think that H-P is cheaper than IBM. Their conclusion is baseless, and if the Motley Fool succeeds in its mission to educate investors, this effect will disappear. In the meantime, low price can make a stock more attractive to some investors.
2. In the same way, stock splits tend to generate a lot of mistaken investing enthusiasm. Stocks that split do tend to do a bit better than the market over the next 12 months, probably because companies that split their stocks do so because the price was rising rapidly before the split due to good fundamentals. That trend often continues. Again, we are trying to educate investors that the fundamentals are what is important, not the split, but that lesson hasn't gotten through to a lot of folks yet.
3. Momentum. Once a stock starts moving back up, it tends to keep going for a while. So people who buy bargains start the process and, as the stock moves up, it starts looking more attractive. Add in the Dow companies' ability to recover from brief periods of poor earnings and you might get a trend.
4. The Beating the Dow effect. As Michael O'Higgins postulated in BTD, Dow stocks tend to get beaten down by bad news more than is really justified. The rebound that follows will show a stock whose price was artificially low, moving up in price relatively quickly.
Not all of these conjectures would necessarily apply to the market as a whole. In general, Dow companies have a solid floor under them. They aren't going to just evaporate into thin air. They may go through some rough patches, but they have the financial strength and sheer mass to weather most storms. That's why they are Dow stocks to begin with. (There are exceptions, of course.)
Just for the record, I don't expect to find a strong statistical correlation between the square root of price and volatility for Dow stocks. I would expect a fairly weak correlation. A strong correlation would have been obvious before now, I suspect.
Also, I am not certain that the correlation will be strictly between price and volatility. Volatility is rapid price movement in either direction. For Dow stocks, it might turn out that the correlation is more directly with positive price performance, because of that floor I just mentioned. But that's just more speculation. Until we have the numbers, we don't really know. And neither does anyone else.
Mr. Zweig had another point to make:
"Referring to the concluding section of my column, Ms. Coleman wrote: 'To me the most revealing paragraph in the whole article is this: "When 90% of professional investors with their MBAs and powerful computers and multimillion-dollar research budgets can't beat the market, why should you believe anyone who says you can do it..."'
"To me that's the most revealing paragraph in Ms. Coleman's response, too. What were the words she chose to omit with that '...' at the end of the sentence? Here they are: 'by day trading.' Did Ms. Coleman disagree with the sentence as I actually wrote it? I doubt she did. So she simply concocted a new sentence she could disagree with, one that directly contradicts my own beliefs. The sentence 'reveals' what Ms. Coleman claims it does only after she deliberately hides the most important part of what I said. By omitting those three crucial words -- and by presenting her doctored sentence as if it were my own original -- the only thing Ms. Coleman has revealed is her own inability to stick to fair facts."
I probably deserve some of this. I left off the last few words in "the interest of space." But since the point of the article was that the Foolish Four was no better than the other practices mentioned, I didn't think I was changing Mr. Zweig's thoughts or intentions at all. He mentioned several bad investing practices: day trading, fund flipping, lack of diversification, and the Foolish Four. All four were described as ways that individual investors could "pick their own pockets." I left out the day trading phrase because it was simpler than explaining all that and because the entire thrust of the article was that you shouldn't believe anyone who tells you that you can beat the market with the Foolish Four.
He went on to say that the new sentence "directly contradicts my own beliefs." Does he believe that the average individual investor can beat the market? If so, he has an odd strategy for doing so -- "a diversified portfolio of U.S. and foreign stock and bond funds that you can hold for years on end." I have yet to see such a strategy that HAS beaten the market over a long time period. Say the last 10 years, during which the Foolish Four strategy returned 22.60% vs. the S&P 500's 19.20% (both figures are CAGRs).
Fool on and prosper!
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Stock Change Last -------------------- CAT - 1/8 60.50 JPM +3 7/16 136.31 MMM + 11/16 90.69 IP + 7/16 54.75
Day Month Year History FOOL-4 +0.91% 2.46% 28.86% 30.78% DJIA -0.31% -0.01% 20.26% 19.78% S&P 500 -1.33% -0.86% 11.30% 11.56% NASDAQ -2.80% -0.04% 22.43% 24.11% Rec'd # Security In At Now Change 12/24/98 24 Caterpillar 43.08 60.50 40.44% 12/24/98 9 JP Morgan 105.51 136.31 29.19% 12/24/98 22 Int'l Paper 43.55 54.75 25.72% 12/24/98 14 3M 73.57 90.69 23.27% Rec'd # Security In At Value Change 12/24/98 24 Caterpillar 1034.00 1452.00 $418.00 12/24/98 9 JP Morgan 949.62 1226.81 $277.19 12/24/98 22 Int'l Paper 958.12 1204.50 $246.38 12/24/98 14 3M 1030.00 1269.63 $239.63 Dividends Received $49.99 Cash $28.26 TOTAL $5231.19