Personal Finance: Fools pick losers and see them grow

The Motley Fool started in the US as an investment newsletter and has grown to a $10m internet and publishing business. At the heart of its philosophy is the belief that anyone can run their own finances better than the so-called experts. The name comes from the wise Fools at the English court, who dared to question the king.

This week: Beating Footsie

DIFFERENT people have different temperaments. Some will stick with an index tracker fund all their lives, others will look for Obviously Great Investments (discussed last week). Some will always feel happier handing over their money to someone else to manage.

Others are fascinated with odds, people who like to put their money on the winning side, even if they don't always win: they know you simply have to win more often than you lose.

In the early 1990s a US money manager, Michael O'Higgins, published his landmark Beating the Dow, outlining a mechanical investment strategy that involved buying those five of the 30 members of the Dow Jones Industrial Average that had been "excessively penalised" by the market; holding them a year, and then rebalancing the portfolio into the next five laggards or "Dogs". During the year the Dogs tended to move up as the market's "excessive" marking down bled away and they came closer to a fairer valuation.

This strategy needed no share-picking skill at all. Buy the shares at the nadir of their disgrace, hold them until tempers cooled, sell at a profit, and you have a market-beating strategy.

But this only works for huge firms with the might to withstand what are essentially gnat bites and can fight back a little later. But how do you identify these companies? Share prices fluctuate according to market whims, but dividends are set by the firms and there is great pressure not to cut them.

First, it looks very, very bad indeed and the implication that the company is in real trouble will only hammer the share price even more. Secondly, shareholders reckon on the dividend for at least part of their income. Cutting it makes them very angry. So, as the share price drops and the dividend stays the same, the yield - dividend divided by share price as a percentage - goes up.

So high yielders are more likely to be shares in disfavour. O'Higgins' system took the 10 highest yielders from the 30 shares of the Dow Jones Industrial Average - some of the largest US firms - and bought the five cheapest, held them a year, then reallocated-allocated to the next "Dow Dividend Five" or "DD5"

What about beating the Footsie? In 1935 the FT30 index was set up as a Dow Jones equivalent. Johnson Fry, a unit trust company, has done some backtesting on returns from the five highest yielders in the FT30 each year against the All-Share index of all shares. From 1970 to 1996, the FT-SE All Share index yielded an average of 15.6 per cent and a total return of 5,028 per cent. The "Footsie 5" highest yielders averaged 20.5 per cent a year with a total return of 15,370 per cent.

We have done some testing of our own: pounds 10,000 invested in 1983 would have been worth pounds 243,000 by January 1998.

Why the five cheapest of the 10 highest yielders? That's the way O'Higgins did it, as a low share price made it more likely - psychologically - that it would climb: investors see a bargain, buy at 200p instead of 500p: it's ludicrous, but it often happens in the market. There's no guarantee this will continue over the next 30 years, but we are firm believers in past performance.

Why use the FT 30 index? It's rarely-quoted and some members have slipped out of the FT-SE 100 biggest UK companies (Courtaulds and Tate & Lyle). But it makes for a group of well-known, large-cap shares with the resilience to withstand a touch of disfavour. Others include ICI, Lloyds/TSB, Boots, British Airways. You can get an up to date list of the FT30 and prices from the Financial Times (see box).

Extracted from the 'Motley Fool Investment Guide' by David Berger with David and Tom Gardner, Boxtree, pounds 12.99. David Berger, David and Tom Gardner 1998. For a copy, post free, call 0181-324 5522.

Next week: the 10 commonest investing mistakes

act on your strategy

1. Choose one day a year for changing your portfolio. Let's say the first Friday of a month, so you can calculate over the weekend and buy shares on Monday.

2. Buy Saturday's FT.

3. Get the current FT30 list from FT faxback 0891 437 014 after markets close on Friday to get closing prices.

4. Write in the dividend yield next to the 30 shares, using prices in the FT.

5. On a separate sheet write down the 10 firms with the highest yields and Friday's closing prices next to them.

6. If you are following the High Yielding 10: buy them in equal pound amounts - the strategy has only been tested with the shares equally weighted.

7. Keep a record.

8. Wait one year.

9. Revisit steps 1-7, and reinvest your dividends.

10. Do this annually.

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