Michael B. OHiggins - Beating the Dow Completely Revised and Updated: A High-Return, Low-Risk Method for Investing in the Dow Jones Industrial Stocks with as Little as $5,000

BEATING
THE DOW

A HIGH-RETURN, LOW-RISK
METHOD FOR INVESTING IN THE
DOW JONES INDUSTRIAL STOCKS
WITH AS LITTLE AS $5,000

MICHAEL OHIGGINS
WITH
JOHN DOWNES

TO

Mimi and Dad for the gift of curiosity,
and to Donna, Mark, Brendan, Colin, and Sean,
whose loving presence helps smooth
out the vicissitudes of investment life

M ICHAEL OH IGGINS

CHAPTER 2 Why Common Stocks Are the Best
Investment for Accumulating Wealth

CHAPTER 4 How the Pros Try to Beat the Market
and Why Most Dont Succeed

CHAPTER 8 Beating the DowAdvanced Method

Conclusion

APPENDIX ARecent Deletions
and Substitutions in the Dow

APPENDIX BA Look at the
Major Outperformers

W HEN Beating the Dow was first published ten years ago, I knew its simple and obvious strategy, based on the resilience of temporarily out-of-favor Dow stocks, would win converts. As a money manager, I had used high dividend yield as a contrarian strategy in all kinds of markets, and its record of consistently outperforming the Dow and most mutual funds was impressive.

At the same time, I expected the simplicity of the strategy would meet with skepticism in a financial community addicted to the notion that anything as important as managing money had to be complicated. There was also the simple fact that contrarianismbuying when others were sellingruns against human nature. And even if individuals could be persuaded that Dow stocks had more resilience than risk, the full-service brokerage establishment would certainly be inhospitable to a formula system that rendered its advisory services unnecessary.

To my own astonishment, and to the credit of my colleagues in the professional financial community, Beating the Dow became the investment discovery of the nineties:

• Average investors moved in droves into a system that featured household names like General Electric and Eastman Kodak. Books and articles began appearing that embraced the system and expanded the underlying research.
• Enterprising financial web sites took the idea and added their own variations.
• A consortium of leading brokerage firms, adapting a legal vehicle traditionally associated with municipal bonds,created the first equity unit investment trusts. Called defined asset funds, they began by holding Beating the Dow portfolios. Then they expanded on the concept, using foreign stock indexes and other portfolios comprising high-capitalization stocks not in the Dow. Equity unit trusts have now become an important industry, led by companies like Merrill Lynch and Nike Securities L.P., with its First Trust products for regional brokers nationwide.
• Mutual funds also began appearing, combining Beating the Dow portfolios with other investments such as SPDRS and zero-coupon bonds.
• The popular newsletter Beating the Dow was a direct outgrowth of the book.
• the Dow Jones business and financial weekly newspaper, began following the system on a regular basis, popularizing the term Dogs of the Dow.

Ironically, 1990, the year Beating the Dow was first released, became the first year in our twenty-six-year research period that the system had a significant negative return. Saddam Husseins invasion of Kuwait and the prospect of war in the Persian Gulf caused a temporary market plunge affecting cyclical stocks in particular. But the following year, 1991, was the second best year in the systems history, led by a 61.9 percent total return for the Beating the Dow Five-stock portfolio.

It is equally ironic that as this revision is about to go to press nearly a decade after the first edition, the system seems headed for its second significant off-year. The problem is not too much popularity. Overly widespread use of the system would cause the Beating the Dow stocks to move as a group and there is no evidence this has happened. In 1998, for example, three of the Beating the Dow five stocks outperformed the Dow, one significantly underperformed and another had a negative return. The reason for a lackluster 1999 is that a superannuated bull market, supported by steady economic growth and low inflation, has relegated value stocks to the sidelines while high-capitalizationgrowth stocks, especially those in computer technology, have been bid up to dangerously overpriced levels.

Prolonged bull markets breed complacency, spawn new era theories that support overvaluation, and make value stocksstocks that are temporarily depressed because of cyclical earnings or other problemsless attractive than stocks with momentum.

Beginning in 1995, we have been witness to a two-tiered market. The blue chip indexes and averages, especially the price-weighted Dow, have been elevated to unprecedented heights by a handful of overpriced and unduly risky stocks, while the rest, on average, have underperformed.

In 1998, for example, the Dow Jones Industrial Average had a total return of 17.9 percent, led by four stocks: IBM, with a closing price of $185, gained 77 percent. Merck closed at $147 and gained 41 percent. General Electric, priced at $102, gained 40 percent. Wal-Mart, at $89, gained 107 percent. Those four stocks had price-earnings ratios of 30, 36, 38, and 44, respectively. The Dows historical price-earnings ratio prior to this bull market was 15.

Another bull market phenomenon has made it more difficult to identify out-of-favor stocks using the high-yield criterion. Combined with the lower long-term capital gains rates provided by the Taxpayer Relief Act of 1997, the extended bull market has made it tax efficient for companies to remunerate shareholders by repurchasing their own stock. With earnings per share spread over a reduced number of shares, share prices rise on the wave of the bull market, giving shareholders favorably taxed capital gains instead of fully taxable dividends.

The effect of stock repurchases has been to reduce dividend yields and force them into a tighter range. This has made the dividend itself a less important part of the total return, and with stocks differentiated by fractional differences in dividend yield, it has become harder to separate the companies that are out of favor from those that may be using their cash in other ways.

Actual stock repurchases under formalized stock-buyback programs can be treated as dividend equivalents, but not all stockbuybacks are designed to compensate shareholders and considerable analysis is often required to quantify those that are.

Finally, the Dow itself has become more growth stockoriented. In November 1999 we saw the deletion of four yield stocksChevron, Goodyear, Sears, and Union Carbideand the substitution of one, SBC Communications, Inc. Of the other three substitutions, Microsoft, pays no dividend and Home Depot and Intel Corp. have a nominal payout. This makes the overall Dow harder to beat with dividend paying stocks.

So for all the above reasons, what has been a simple way of beating the Dow over many years has temporarily become less clear-cut. But the operative word is temporarily.

Dividends will be back. They are a corporations way of competing for equity capital and will be paid again when companies run out of excess stock to buy and when the end of this remarkable bull run makes capital gains harder to come by.

Value stocks will be back in vogue when complacent investors are reminded that high price-to-earnings ratios represent unacceptable risk. As this is being written, Janus Funds, one of the most successful mutual fund groups in the last few years, has just announced two new value funds.