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.)
