LEXINGTON, KY. (April 16, 1998) -- In Part 1 of my Dow Approach "Nuts & Bolts" column yesterday, I outlined the first two of three primary Dow Dividend Approach alternatives -- the straight High-Yield Approach and the more concentrated Foolish Four variation we follow daily here at the Fool. In Part 2 today, I'll conclude with the third major approach -- the RP Variation.
Whereas the High-Yield Approach focuses strictly on the ten top-yielding Dow stocks, and the Foolish Four adds a second screen to choose four of the lowest-priced stocks from those ten, the RP Variation uses a single ratio which incorporates both elements (high yield and low price) simultaneously to generate a combination ranking for each of the thirty stocks.
This is often an important element because the dual and discrete screens used by the Foolish Four can lead to some illogical rankings fluctuations. For example, when a stock is #10 on the High-Yield list and #2 or #3 on the low-price list, it's one of the favored Foolish Four stocks. The very next day, let's suppose, the stock's price rises just enough that it falls to #11 on the High-Yield list, even if only by one one-hundredth of one percentage point. Poof! It's gone completely from consideration for the Foolish Four. Around the fringes, such fluctuations aren't rational, but we live with them because of the long-term success of the Foolish Four system.
The RP Variation, however, combines both yield and price in a simple formula that can be applied to all 30 Dow stocks, relieving us from the artificial cut-off after identifying the top ten yielders. The formula is simple: Dividend Yield times Dividend Yield divided by Stock Price. (To make the numbers more manageable, I list the yield in whole numbers rather than in its actual decimal equivalent. That is, instead of listing a 1.5% dividend yield as 0.015 in this formula, I leave it as 1.5. It doesn't affect the ratios for each stock relative to all the others and it makes the calculation easier to read.)
For example, if Sheard Enterprises (Nasdaq: WISH) has a dividend yield of 2.76% and a stock price of $47 per share, the RP Ratio for it would be:
The reason for squaring the dividend yield is that, of the two elements, the dividend yield is more important than the low price, so the RP Ratio equation gives it more weight. Once this calculation is done for all thirty stocks, they're ranked in descending order. (The stock with the largest ratio is #1.) In his original research, Bob Price (TMF Sandy) determined that the best course is to skip the #1 stock and purchase the next four in equal-dollar amounts and then hold them for at least one year.
The RP Ratio for a stock in a bit of financial difficulties can be inflated (too much of a good thing), and the investor is better served by overlooking that top-ranked stock more often than not. For much the same reason, the Foolish Four often skips the #1 stock in its own ranking system.
Using the same historical period I discussed yesterday (1971 - 1997), the RP Variation has generated a compound annual return of 24.2%. (If you recall from yesterday's column, the Foolish Four return was 22.0%, the High-Yield 10 return was 17.5%, and the Dow 30 return was 13.7%.) A $10,000 investment in the RP4 in 1971 would have grown to more than $3.4 million by the end of 1997 (excluding trading costs and taxes).
There you have it, Fools. Three major approaches to high-yield investing on the Dow: the straight High-Yield Approach, focusing on nothing but the highest dividend yields; the Foolish Four, which uses two separate screens to test high yield, then low price; and the RP Variation, which uses both high yield and low price in a single combinatory equation to select the best candidates for the coming year or two. All three methods haven proven successful and consistently out-perform the market indices the majority of professional money managers lose to year after year. Choose the one that fits your portfolio requirements the best and Fool on!