Rule Maker To Buy Fool-4
March 09, 1998
**When Rule Maker announces an intention to trade, that trade will be made within the next five business days, as opposed to the very next day. For more detail on how buys are determined and how this portfolio originated, please read the "11 Steps to Rule Maker Investing" section of the Rule Maker Portfolio.**
Rule Maker Portfolio Buy Report
Purchasing $1,250 in General Motors (NYSE: GM) stock
Purchasing $1,250 in Chevron (NYSE: CHV) stock
Purchasing $1,250 in Eastman Kodak (NYSE: EK) stock
Purchasing $1,250 in Exxon (NYSE: XON) stock
For over a month now we've promised that the Rule Maker Portfolio would include a value component in the form of the Foolish Four or some variant of it. In the 11 Steps mentioned above, we outlined our plan to dedicate 75% of our $20,000 portfolio to Rule Maker growth stocks and 25% to the sort of high-yielding Dow stocks written about in the Motley Fool's Dow Approach Area.
That decision has been fairly controversial from the get-go. A collection of Foolish contributors on our message board wondered why we'd foul up a great long-term, fundamental approach to the stock market by including a shorter-term, mechanical model. It was even suggested that we now rename the portfolio "The Cash-Prince Portfolio," since we planned to swerve from the pure growth characteristics of Rule Maker investing. While we've chosen not to rename the portfolio, we do feel the need to justify our inclusion of this more defensive approach.
Why put the Fool Four or some variant of it in the Rule Maker Portfolio?
To answer that question, we need to review a few very basic investment precepts. Investors are always eager to buy the highest-quality businesses at the lowest prices. That's the ideal. Many scour the market universe in search of stocks with low price-to-earnings ratios and exciting prospects.
The problem is, top quality doesn't often hang out at the Dollar Store. You have to pay up for the best computer; you have to shell out extra bucks to live in an oceanside villa on Maui; you have to make sizable contributions to eat dinner with the President or sleep in Abe Lincoln's bedroom. Those things don't come cheap. And the same is true in the stock market. Even though our public markets are far from perfectly efficient, it does get more difficult each day to find great businesses trading below or at the market's average P/E ratio. Why? Because the pool of investors is getting smarter by the hour.
Given that Foolish reality, we've decided to mix two investment approaches in our portfolio -- each of which we think will provide market-beating results over the next two decades.
1) A long-term growth strategy designed to locate the stocks of companies expanding so profitably and so methodically that their current price is of little import to us.
2) An intermediate-term value approach that searches for defensible large businesses that are attractively priced relative to the overall market.
At any given time, one or the other approach will rule the day. By using both of them, we hope to protect ourselves against the extreme emotionalism that can crop up during the broadest swings of the pendulum.
For example, take the stock market between 1973-1974, a very different market than the one we've experienced over the past three years. Over that two-year period in the 1970s, the Dow Jones Industrials dropped more than 30%. One of the best performing U.S. stock of the 20th century, Coca-Cola, fell 67% from peak to trough. Fool, take a look at your portfolio today. Now reduce it in size by 50-60%. Next, imagine yourself lying in bed at 2 a.m. after that dramatic fall. Are you sleeping? Comfortably?
If you are, ignore this buy report. If you're not, you can begin to understand why we're adding a more defensive, value component to the Rule Maker Portfolio. Because during that 1973-1974 bear market, when the market fell more than 30%, the Foolish Four stocks actually rose 35.6%. There's no guarantee that the same scenario would play out in a tumbling market, but logic does support that the Foolish Four would act as a hedge in dark times.
Over those twenty-four humbling months in the early '70s there was a profound shift away from high-growth companies and into defensive businesses -- chemicals, steel, oil. Consumer franchises (particularly consumer electronics companies and retailers), which had been bid into the ether, corrected sharply. It took years for many of them to return to previous heights. In fact, from high to low, Coca-Cola took more than ten years to return to its pre-1973 peak. In the meantime, the high-yielding stocks on the Dow Industrials (The Foolish Four) were chugging along. Get this... between 1973 and 1983, the Foolish Four stocks rose 1170% while the Dow Jones Industrials rose a mere 172%.
Wow! I have to write that again for emphasis:
Between 1973 and 1983, the Foolish Four stocks rose 1170% while the Dow Jones Industrials rose a mere 172%.
That ten-year period of rising interest rates, stagnating growth, Boogie Nights, and round-the-block gas lines is the foundation for the Dow Dividend Approach. Yes, the American markets in the 20th century have been driven by growth, and so it will be in the 21st century. But sometimes we plod through markets in which the very defensive, unsexy business reigns supreme. To our thinking, a portfolio that recognizes only one of these styles will endure a more erratic performance than one that uses some balance of the two.
We're shooting for the latter. We're going out in search of a market-beating value approach to add to our growth investing, and the one we've chosen is none other than the tried and true Foolish Four (with a twist). It's an approach that has produced returns of almost 22% annually for the last 27 years -- smashing the market. Details of the approach can be found in our Foolish Four Area. But before you click there and realize that we haven't selected International Paper, AT&T, DuPont, and Exxon as our four, read on.
A New Twist on the Fool Four
A couple weeks ago, Robert Sheard released news of some new work done by Bob Price (TMF Sandy) on the RP variation of the Foolish Four. That work is described at (click here) The RP Variation and then followed up again by Robert Sheard with (click here) More on the RP. Please read those two articles because they supply a more thorough examination of this new Foolish-Four variant than we plan to offer here. The new variation has you carrying out the following calculation on all thirty Dow stocks:
(dividend yield x dividend yield) / share price
The RP investor ranks the thirty stocks from those with the highest ratio to those with the lowest, then kicks out the company with the highest ratio, and then buys the companies with the four highest remaining ratios. Doing so today leaves us with our four stocks -- General Motors, Chevron, Eastman Kodak, and Exxon. This new model focuses investors much more intently on both features of high-yield investing: the low share price and the high dividend yield.
What about the historical returns of Bob Price's model? Here they are:
Annual Growth Rates RP Fool Four Past 5 Years: 25.53% 21.29% Past 10 Years: 23.36% 20.92% Past 15 Years: 25.04% 21.66% Past 20 Years: 24.32% 20.87% Past 27 Years: 24.16% 21.97% Past 37 Years: 19.64% 18.20%
Those RP figures look even more attractive when stacked up against the Dow Jones Industrials' 30-year annual growth of about 13% per year.
Our current plan is to rotate the stocks every 18 months and to take advantage of the minimum capital gains rates available. We will be reflecting capital gains taxes in the Rule Maker Portfolio. For this reason, our inclination is to go with the 18-month rotation period, but we're not going to commit quite yet. The same Fool who built the RP approach, Bob Price -- TMF Sandy (what a busy guy!) -- is hard at work putting the finishing touches on a study to determine whether holding for eighteen months and paying 20% (not 28%) on all capital gains outperforms the twelve-month Foolish-Four performance over the past few decades. We're in no rush to commit either way until we see Bob's work.
And that's pretty much all she wrote. We'll be adding the RP stocks at some point over the next five days. Again, they are General Motors, Chevron, Eastman Kodak, and Exxon. The Rule Maker Portfolio will buy approximately $1,250 worth of each.
Finally, please do read the two articles appearing in our Daily Dow column on Bob Price's RP approach:
1. The RP Variation
And if you have any questions or comments about this report, drop by our (click here) Rule Maker message folder and let us know what you're thinking. And for more on the RP approach, also check out the Dow Dividend Approach/Foolish Four message folder.
- Al Levit