It's the idea that choosing our stocks from the magical, mystical Dow is one of the reasons why the Foolish Four strategy has worked so well.
I don't think so.
The genesis of the Foolish Four is Beating the Dow by Michael O'Higgins. Let's see what he says about why he picks stocks from the Dow:
"By virtue of sheer size and strength -- call it raw staying power -- blue chip companies tend to be survivors. The old adage 'the bigger they are, the harder they fall' doesn't hold when you're talking about corporate giants. Blue chip stocks are usually safer investments than other kinds of stocks.
"The investing public invariably over-reacts to unfavorable developments. This creates special opportunities when you're dealing with blue chips: Bad new is good news because it makes strong stocks cheap."
Now do you see anything up there that is exclusive to the 30 stocks selected to be on the Dow Jones Industrial Average? I don't, and I don't see anything anywhere else in the book that suggests it. O'Higgins makes it clear that he chose the Dow for three reasons. It guaranteed that the stocks were "blue chips," meaning strong, well-known companies. It was small enough to work with, and if you "beat" it, you were beating the market. There was no Dow magic. In fact, the Dow is used simply for convenience.
It is very convenient. You can find the member stocks listed just about anywhere these days and, recent events not withstanding, it doesn't change all that often. It also gives us a convenient standard against which to measure performance. But what makes the Foolish Four work is not the pool from which the stocks are picked. It's the very old principle of value investing.
Looking for strong companies that are priced cheaply because of over-reaction to bad news is nothing new. It's about as basic as "Buy low, sell high." (I've never been sure whether that old adage was a joke or not.)
If the editors of The Wall Street Journal went out tomorrow and decided to replace every stock on the Dow with companies that end in dot-com, would the Foolish Four still work? Obviously not, since the strategy relies on dividends to identify the underpriced stocks. But, would a strategy of investing in the dot-com stocks that were currently underpriced due to investor over-reaction work? Well, maybe. IF the dot-coms were all very strong, financially sound companies with well-accepted products (like, don't they wish!), it probably would. However, we would have no way to know that because it would be impossible to backtest such a strategy.
Which brings us to our current dilemma. Just how reliable are our backtested returns? Is today's Dow enough like the Dow of the '70s and '80s that those results are still likely to say something about the future? I don't have the answer yet. I'm still looking.
But more than that, I am questioning our reliance on the Dow in the first place. Are we relying too much on convenience and tradition? We can see the strategy working in the past, which is a very big factor. But suppose we had a different universe of blue chip stocks to pick from? The Beating the S&P list is one possibility. We already know that the principle of investing in low-priced, high-yielding stocks has worked extremely well in that universe for the last 12 years.
The Beating the S&P strategy is proving to be more and more valuable as time goes by. At first it was an interesting experiment to see if the High Yield/Low Price idea would work outside the Dow. Wow, it sure did. The two strategies validate each other and address one of the most common criticisms of mechanical investing strategies, which is that they are just due to chance.
Now it has me thinking that we need to consider enlarging our horizons. The Foolish Four might be ready for a bigger pond.
Fool on and prosper!
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