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Thursday, September 8, 2011

Fool’s Four stock investment strategy

Let me first assure readers that the Fool’s Four (or Foolish Four) stock investment strategy is neither foolish, nor is it meant to make fools out of investors. It is a ‘mechanical’ investment strategy that can be useful for those investors who haven’t yet developed their stock-picking skills, and have probably lost money chasing ‘cheap’ small-cap stocks.

The Fool’s Four strategy was designed by The Motley Fool investment group as a refinement to the Dogs of the Dow strategy. I had written about the Dogs of the Dow strategy in a post back in Apr ‘10. The strategy works just as well with Sensex stocks. (If you are a recent visitor to this blog, or have forgotten what I wrote more than a year back, you may want to read the earlier post first.) 

Since it is a variation of the Dogs of the Dow strategy, the Fool’s Four involves selection of four stocks from the Dow index (or Sensex) based on low price and high dividend yield. The dividend yield is calculated by dividing the actual dividend per share in Rupees (not the percentage dividends usually announced) by the current market price (CMP) of the share in Rupees.

The selection process involves calculating the square roots of the CMPs, and the dividend yields of each of the 30 Sensex (or Dow) stocks. Next, divide the dividend yield by the square root of the CMP to find a ratio for each stock. Then rank the 30 stocks based on a descending order of ratios (i.e. the stock with the highest ratio will have a rank of 1, and the stock with the lowest ratio will have a rank of 30).

If calculating the square roots of the CMPs is too much of a challenge, you can calculate the square of the dividend yield (multiply the dividend yield by itself) and divide it by the CMP. The ratios will be different, but the rankings will be the same.

Now comes the interesting part. Drop the stock with the rank of 1, and choose the next 4 (ranked 2 through 5). Buy equal Rupee (or Dollar) amounts of each of the short-listed four stocks, and hold them for a year. Why drop the stock with the number 1 rank? There is a good possibility that it may be in financial difficulties. Sensex (or Dow) stocks are supposed to be financially stable, but the odd JP Associates do get in trouble by being over-ambitious.

Is there any logic behind the Fool’s Four strategy, or is it just some foolish number crunching? Apparently, academic studies have proven that (a) high dividend yield leads to better market performance (which is the logic behind the Dogs of the Dow theory); and (b) stock price variations (or ‘beta’) is correlated with the square root of the price.

So, the Fool’s Four strategy gives slightly better results than the Dogs of the Dow (or Sensex) strategy. That doesn’t mean that all four stocks will beat the Sensex. The underperformer(s) should be replaced by stocks from the short-list of four selected next year. The Sensex-beaters can be retained.

(Note: Interested readers can do the exercise of selecting the four stocks from the Sensex that meets the above selection criteria. I’ll post their brief technical analysis once I receive your feedback. Then we can check back after one year and see how well the strategy works.)


N said...

Interesting and informative as always. Your blog is on my essential daily reading list!

It may be worth mentioning that the developers of the Foolish Four model have changed their views since they first advocated it.

They are now of the view that statistical flukes resulted in higher returns, and that there is no strong evidence to support dropping the first ranked company.

Overall, the developers now conclude that the model may offer returns only slightly above average.

Anyone interested in reading their full reassessment can do so here

Jasi said...

Pretty interesting post. I never had heard of it. How is the data regarding its success? Has it indeed consistently beaten Dogs of the Dow or Sensex?

Secondly, are you REALLY suggesting going purely mathematical once a year, invest and then forget about it? :)

Finally, what if one wishes to allocate a specific sum every month, a la SIP, to shares? How does that work for Dogs or Fools theory?

Thanks a tonne, as always! your posts are such a delight.

Subhankar said...

@N: Appreciate your comments.

Any 'mechanical' formula-based system will be useful up to a point. If everyone starts using it, it loses its effectiveness.

I have a not-so-hidden agenda in writing posts like this. May be it will motivate small investors to buy large-cap index stocks instead of chasing after 'cheap' multibaggers. The Fool's Four is more likely to give positive returns instead of losses - even if it doesn't beat the index by much.

@Jasi: I have no data to 'prove' that the Fool's Four can beat the Sensex - but it seems logical, and you may be surprised by the stocks that make the list.

The Dogs of the Dow and the Fool's Four are supposed to be buy-once-and-forget-for-a-year strategies. For less experienced investors, such strategies will take guesswork and over-trading off the table. SIPs should work, as long as each month's investment is tweaked after 12 months, if required.

Harry said...

Hi Subhankar, great articles, this one and the next.

To add to Jasi's point and your response, if the intent is to do an SIP every month, there is nothing stopping someone from regenerating the list every month, or even every week. It is going to be more work, and tracking too many stocks might be an issue, but it might prove "slightly" better than decide once a year plan. I do not know how the markets will be in the next year, but we are in volatile / turbulent times and stocks go through huge gyrations for no reason. Maybe you will get an opportunity this month (JPA for example at 55) but a different opportunity next month (LT for example at 1400), so why not make use of them all.

Again, as long as the idea is to be mathematical and not emotional, and has solid underlying foundations, it might work. As I was discussing with a friend re some trading strategy, if I can build a spreadsheet model with 1 row (scrip), I can scale that to 100 rows at almost no cost. The only overhead is the data entry (and tracking), thinking comes free and is already part of such model !!

Jasi said...

@Harry! Guess what, that is what I was contemplating too. Generating the list every month and it isn't a great deal of effort from first looks.
I would like to understand a bit more what you spoke in the last para regarding excel sheet. It sounds interesting but was largely OHT (overhead transmission), so would reqyuest you if you may re-word it.

Thanks Subhankar Sir and every one else.

Jasi said...

Correct me if im wrong, but I believe this also takes away that timing the market urge or necessity. Right?

Subhankar said...

@Harry: Appreciate your comments.

The Fool's Four strategy and the Dogs of the Dow strategy selects under-performing large-cap stocks - with the hope that they will out-perform over the longer-term. If every one starts following the same strategy, out-performance is unlikely.

Mechanical investing or trading systems are supposed to take the guesswork out of stock selection. Investing in a good large-cap fund or an index fund may work just as well.

@Jasi: Timing the market requires a lot of skill and experience, and is not recommended for small investors. Programmed or systematic investing takes the timing problem out of the equation.

Harry said...

In response to Jasi's OHT comment. Sorry it has become overtly long... there is some repetition but that's intentional.

Let's assume you have a model which works. It might be fools's four, or it might be based on P/E, or it might be based on pledged shares ... does not matter. I am assuming that your model works. Let's also assume that it is based on some numerical parameters (P/E, bottom 4 are numerical) rather than charts (where we need to manually check whether the trendline was broken and if yes at what angle and how fast etc etc). RSI as an example would work because it is a number. Do note that I am not distinguishing between parameters ... they can be fundamental or technical parameters.

Once you have a winning strategy / model, isn't it just a question of building one excel model to track all these? I know excel, but don't technical tools like MetaStock do the same by looking up various parameters and then giving a call.

And once you have the model (again assume it works), the frequency of such purchases is just a parameter. You test out (or think through) the limits ... will it work on yearly, quarterly, monthly, weekly, daily or intraday basis. Assuming it does, you can scale it to make purchases on demand.

And once you have the model, the number of scrips is another parameter. Again, after thinking through ... you can pick 4. you can pick 3, or you can pick 5.

When to sell is another parameter. You can test out and see whether you want to sell once a year to take LT gains, or to sell on a 10% profit, or to do it every day ... whatever.

Bottomline is that once you figure out the model, and understand its boundary conditions (extreme situations) and granularity (monthly, daily) ... it is just a question of translating that to a spreadsheet.

If you can manage buying 4 stocks once in a year, you can manage buying 4 stocks once in a quarter with very less incremental effort, and you can manage buying 4 stocks once in a month with less incremental effort.

That's what I meant ... not sure if it came clear this time too. I think of it as "personal level high frequency trading" ... or investing which is used by the FIIs all over the world.

Just FYI - I do not use exactly the same model (fool's) but have a spreadsheet driven model which helps me manage about 20-25 stocks without much thinking on a day to day basis. I am new to trading / investing and I actually failed the test when the market went under 4700 recently ... I panicked ... however, in hindsight, it was only a question of knowing the extremes better and tuning the model. Before the spreadsheet (which probably has 5-6 fundamental values about the company), I could barely manage to monitor 5 companies.