The Rule Breaker Portfolio

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Foolish Four Switch
Plus, AOL splits to penny-stock status(?)

by Jeff Fischer ([email protected])

ALEXANDRIA, VA (Feb. 22, 1999) -- Today we announce our annual Foolish Four switch. Every twelve months (plus one day for tax reasons), we reconfigure our Foolish Four holdings, dropping the stocks that no longer qualify and adding the new lucky few that are on the list.

Why are they lucky? Because stocks on the Foolish Four list are typically looking ahead at a brighter future. In the next year, they have historically outperformed the stock market indices. This is why the Foolish Four has returned 22% annually over the past 26 years (double the S&P 500); this is why we have a real-money Foolish Four portfolio in our Hall of Portfolios; and this is why we use it as a foundation in this portfolio and others. Many Fools use the Foolish Four not only as an investing foundation, but as a foundation, first floor, second floor, third floor, and roof. The Foolish Four is an investment method that alone can be more than adequate for a lifetime.

So, as always, we're using it. And, as always, we're updating it after 12 months.

The only new element this year is that we're using the RP variation of the Foolish Four. In fact, the RP is now the official representative of the Foolish Four on the Fool, and has been for months. "RP, what's that?" you might ask. It's already been written about extensively on the site, so let me pull back the curtain and point you in the right direction:

The Foolish Four Explained

OK. You're still here. Good. The RP is based on the same Foolish Four philosophy that all of the method's variations depend upon. The highest-yielding Dow stocks constitute the initial list. Now, quoting from Ann Coleman (TMF AnnC), here's the formula for finding the RP Foolish Four stocks:

1. For all 30 Dow stocks, square the dividend yield and divide by the price.

Yield x Yield 
-------------  =  RP Score 
    Price

2. Rank each stock by the RP score in descending order (highest score first).

3. Drop the top-ranked score (highest RP value) and buy the next four in equal dollar amounts. Buy and hold for at least one year.

The RP variation has rolled up some impressive historical performance numbers. Over the past 25 years, the RP has returned an average 24.66% per year. Consider these numbers:

S&P Index Fund:  $215,208.12 
High-Yield 10:   $585,606.67 
Foolish Four:  $1,425,651.37 
RP Variation:  $2,471,426.87 

Those are the values achieved at the end of 1997 by hypothetical portfolios begun 25 years before with an initial deposit of $10,000 and no additional money added (and dividends reinvested, of course). It bears repeating: the S&P 500 Index Fund would become $215,000. The average mutual fund: less than $180,000. The Foolish Four RP: $2.4 million.

Another impressive thing about the RP variation is that the higher returns are actually more consistent than the straight Foolish Four's returns. Here's how the two strategies have performed over the 10 years from 1988 through 1997:

      Foolish 4  RP Variation
1988  13.62%     22.08% 
1989  15.28%     47.45% 
1990 -17.61%    -17.61% 
1991  81.61%     34.81% 
1992  29.94%     29.94% 
1993  26.22%     30.26% 
1994   4.72%      7.60% 
1995  30.58%     47.05% 
1996  24.34%     26.56% 
1997  22.31%     19.49% 

You can see why the Rule Maker Portfolio, our real-money Foolish Four Portfolio, and now this portfolio use the RP version of the Foolish Four. To learn more about the variations of the approach, see the link above. To see which stocks make up the various Foolish Four approaches any particular day, visit the Fool's always-updated list.

Many of these stocks are close to 52-week lows and they have the highest dividend yields of the Dow stocks. For example, Peoria-based Caterpillar trades at 11 times earnings and yields 2.6%, and Chicago-based Sears is at 15 times earnings and yields 2.3%; both are at significant discounts to the average P/E on the Dow and the S&P.

We sell two Foolish Four stars tomorrow, AT&T (NYSE: T) and with it Lucent Technologies (NYSE: LU), because Lucent was spun-off from AT&T and was held as part of our Foolish Four strategy. We'll also sell Exxon (NYSE: XON) and International Paper (NYSE: IP). All but International Paper were winners for us (Exxon only slightly), but this methodical investment model works because it is... methodical. To be extreme: if an investor didn't follow the method and switch each year, he might still be holding some stocks from the '70s and '80s that aren't even on the Dow anymore. So thanks for the memories AT&T and Lucent. Perhaps we'll see AT&T again in the future.

We've seen Sears before, in 1994 and 1995, and we almost saw her again. Sears was on the list Friday but was bumped off at the close today. So, tomorrow we're set to buy Caterpillar (NYSE: CAT), Chevron (NYSE: CHV), and Goodyear Tire (NYSE: GT). We'll be picking up about $14,000 worth of each. To balance our other Fool Four position, we'll buy slightly more DuPont (NYSE: DD) tomorrow, so it'll be worth $14,000, too, at the start. That's how the Foolish Four should begin: each holding should be balanced.

After the trades are complete, we'll have $56,000 invested in the Foolish Four, or about 10% of the portfolio. We've said in the past that we'd try to keep our Foolish Four holdings at about 20% of the portfolio's total value, but we'd rather let our winners run than sell some America Online, for example, in order to buy more Foolish Four holdings. If the Foolish Four outperformed the rest of the portfolio, we'd roll most of the money earned from it into the Foolish Four again each year, letting it grow naturally due to its own performance.

This is how we'll approach it in the future, too: we'll roll our Foolish Four cash into the new Foolish Four each year, but we won't likely add to our investment or subtract from it, either. So, whatever portion of the portfolio that the Foolish Four becomes, it becomes so of its own accord. Here's the sell and buy trade announcement for tomorrow. If you wish to discuss this trade or the portfolio, please visit the Rule Breaker message board.

TODAY

The Dow and S&P soared over 2% to land near new all-time highs. The Rule Breaker jumped over 4%, adding to a similar gain on Friday.

America Online (NYSE: AOL) will split 2-for-1 this evening, meaning that tomorrow it will open at half its closing price today. It also means that AOL is our first penny stock.

Although the Fool bought the shares at $57 in August of 1994, following stock splits, our cost basis as of tomorrow will be $0.91 per share. Yup, it's "a penny." And to think: when David and Tom bought the stock, Barron's, The Wall Street Journal, and countless journalists said that it was incredibly overvalued, that it traded on "hype," and that the volatility of the shares was dangerous. Sound familiar? Many journalists still write these same words about Internet stocks.

One headline from today reflects the same inept attitude about the Internet. Witness ... (drum roll)... this stunning headline and story:

AOL, Yahoo! Rise on Optimism That Internet Growth Isn't Over

Santa Clara, California, Feb. 22 (Bloomberg) -- Shares of America Online Inc., Yahoo! Inc., and eBay Inc. led online companies on optimism that the growth of the Internet will continue.

Shares of Internet companies have slumped in the last month on concern that their growth prospects didn't justify their high-flying stock prices. Now, investors are moving back into Internet shares at lower prices as they see evidence of the industry's continued growth.

Yes. Now we can all rest assured that the Internet is still growing. We'll have to discuss this incredible revelation later. On that note, Fool on.

Check out what Harry Jones is doing this week.

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