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Author: drosophilosopher Three stars, 500 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 40850  
Subject: Don't Panic 1 Date: 11/5/1999 9:27 AM
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Delurking for a while… just to say "Don't Panic".

There has been a lot of action on this board lately in response to the recent change in the Dow, and most of the reaction has been panic. But why?

1. Sears and Goodyear dropped off the Dow and they were in the Foolish Four.

Well, these things happen. We are now on the 19th version of the Dow since January 1963 (although some of those changes were due to mergers, acquisitions and symbol changes). Small comfort, but how about this. Since 1963, most of the gains that were made by the RP4 stocks were made between December and February, regardless of when they were picked. Read that again. It means that even if you picked the RP4 stocks in March, or July, or October, most of the gain in price would occur from the following December to the following February. They would have done OK the rest of the holding period, but the winter was the best time to be hanging on to them. This is why DHatch and I suggested overlapping 14 month holds using margin as a possible way of juicing the FF a little more. Maybe some day I'll post the backtest data on that. We are just getting into that period of time, so my prediction (based on the last 36 years of RP4) is that Sears and Goodyear will recover somewhat between now and Groundhog day. No guarantees, of course.

2. Microsoft and Intel pay minimal or no dividends, so the FF will never pick them.

So? The FF is not guaranteed to periodically pick every stock in the Dow. Look at the last 36 years (all the data that follows is from TMFSandy's database (thanks again, Bob & Ann!) and is based on January starts). The RP4 method has never picked Wal-Mart, Disney, Coca-Cola, Procter & Gamble, Boeing, General Electric, Merck, DuPont, McDonald's, Alcoa, United Technologies, 3M, or Hewlett-Packard. It picked IBM once, in January 1993. But it still outperformed the DJIA.

3. It's obvious that Microsoft and Intel will be the best performers in the Dow, and the FF method won't pick them. Therefore the FF is no good.

The Foolish Four is not supposed to pick the best stocks in the Dow. In fact it rarely has. It's just supposed to pick a small group that is likely to be better than the average DJIA stock.

In the 36 years from January 1963 to January 1998 the RP4 has included the best performing Dow stock of the year only 8 times. The last time it picked the best Dow stock was January 1992 when Union Carbide (!!!) was the RP#3 pick, and turned out to be the best performer in the Dow that year.

How often does the FF method even pick out one or more of the top 4 stocks of the year? In only 22 of the last 36 years. It has only picked two of the top 4 stocks in 5 of the last 36 years, and it has never picked more than two of the top four. The last time it picked two of the top four was 1982 when Goodyear (!!!) was RP#4 and the top performer, and Sears (!!!) was RP#2 and the second-best performer.

When was the last time the RP4 method picked one of the top 4 Dow stocks for the year? 1995 when Philip Morris (!!!!!!!) was the RP2 pick and was the fourth-best performer in the Dow.

I didn't plan it this way, I was as surprised as you are to see the currently hated quartet of Union Carbide, Sears, Goodyear, and Philip Morris turning up as the answers to these questions. But then, the RP4 is not supposed to pick stocks that you are already in love with, you can do that without a formula. And it still beats the DJIA most of the time.

4. The Dow is changing, the economy is changing, companies don't pay dividends any more, so the FF method won't ever work again.
Seems like an extreme extrapolation based on no data. The success of the BSP suggests otherwise. There are still plenty of good companies out there that pay dividends, and using past dividends as a surrogate for expected earnings is still a reasonable approach. The Dow may not be the best universe of stocks to choose from, but maybe it never was the best one, just a handy one. I support the idea of creating a new Foolish Four based on the principles of the BSP method, but without eliminating the Dow stocks. And why stop at 30? Why not go through the Business week S&P500 list, and pick the top 3 market caps from each industry sector, eliminating those that are smaller than the average market cap, eliminating those that don't pay dividends, and eliminating transportation and utilities? This list would approximate the current Dow plus the current BSP, but is more like an independent index based on similar criteria. Hard to backtest, but it's based on thoroughly backtested ideas. I may just put my money where my mouth is and fronttest this idea.

P.S. Read the FAQ: http://boards.fool.com/Message.asp?id=1030001006587000
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