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

Michael B. O'Higgins, John Downes

• Publisher: Harper Business
• Year: 2011
• Print ISBN:
  9780066620473
• eBook ISBN:
  9780062043580
• Topic: Business
• Subtopic: Decision Making
• Index: Business

PART I

INTRODUCING

THE DOW

STOCK SYSTEM

CHAPTER 1

Keep It Simple!

IN 1985 Texaco, America’s third largest oil company, was ordered to pay Pennzoil Company a huge $10.3 billion judgment. In 1987 Texaco filed for bankruptcy. Its stock plunged 28 percent to $27 a share. In 1989, with the legal claim settled, a postbankruptcy share of a restructured Texaco sold at nearly $60, a new all-time high. Although it would be deleted from the Dow in 1997, Texaco was selling ten years later at more than twice that value, and that was after a two-for-one stock split!

When deadly gas leaked from a pesticide plant in Bhopal, India, in 1984, killing over 3,300 people and injuring thousands more, Union Carbide Corporation, America’s third largest chemical company and owner of 51 percent of the plant, was sued for over $3 billion. Its stock sank 21 percent to $11, but it bounced back in 1985. In 1989, the Bhopal litigation settled. Union Carbide shares hit an adjusted all-time high of $33. A decade later, having spun off its industrial gases division in a transaction that gave shareholders a 70 percent return in 1992, a significantly downsized Union Carbide, since acquired by Dow Chemical (no relation to Dow Jones) and dropped from the Dow Jones Industrial Average, was trading at over $60.

Early in 1989 the tanker Exxon Valdez, owned by America’s third largest industrial corporation, ran aground in the pristine waters of Alaska’s Prince William Sound. In a tragedy that inspired T-shirts reading “Tanker from Hell,” it spilled enough crude oil to cover the state of Rhode Island. Exxon stock dropped 7 percent on the news but quickly rebounded to over $40. In mid-1999, on the eve of its merger with Mobil and after splitting two-for-one in 1997, Exxon was selling at over $80.

I’ve made three long stories short, but these anecdotes—and I could cite many more—have a common lesson:

By virtue of sheer size and strength—call it raw staying power—blue chip companies tend to be survivors. The old adage “the bigger they are, the harder they fall” doesn’t hold when you’re talking about corporate giants. Blue chip stocks are usually safer investments than other kinds of stocks.

The investing public invariably overreacts to unfavorable developments. This creates special opportunities when you’re dealing with blue chips: bad news is good news because it makes strong stocks cheap.

Here’s another fact about today’s financial markets:

Contrary to popular belief, large institutional investors, who dominate market volume and cause sharp volatility through program trading, have created more opportunities than disadvantages for personal investors.

Many individual investors turn to mutual funds as a solution to volatility, but the funds are actually part of the problem. Seventy-five percent of them fail to match, much less beat, the Dow and other market indexes. Their flexibility is seriously constrained by size, competitive pressures, liquidity responsibilities and diversification requirements. Together, these factors lower investment returns, increase transaction costs and necessitate trading practices that cause wide price swings, many of which are merely technical.

You can use the flexibility you have and that the mutual funds and institutional investors lack to actually capitalize on the volatility they create. Beating the Dow will show how you can outperform the pros, simply and conservatively, with your own portfolio of common stocks.

When it comes to accumulating wealth, common stocks historically have been unrivaled by any other investment alternative, including real estate and gold.

The uniquely simple system revealed in Beating the Dow has with remarkable consistency outperformed the Dow Jones Industrial Average (DJIA). I make the 30 Dow industrial stocks—all leading blue chips—your total investment universe, and I identify the laggards and potential winners within it.

My approach to common stock investing is so simple anybody can use it and have fun doing it. It is a direct outgrowth of my personal philosophy, which I learned as a young broker before I became a professional money manager—keep it simple.

Within the small Dow stock universe there are dramatic profit opportunities for individual investors. The key is that in relation to each other, there are always Dow stocks that are doubling, moving sideways, or going down. Beating the Dow shows how to identify the winners when they are out-of-favor and can be bought at bargain prices.

The companies that make up the Dow are household names that are among the most publicized, analyzed, and widely held stocks. Their immense asset values, financial resources, and economic importance give them strength, adaptability and resilience. As a group, they include the most viable business enterprises on earth.

Part II of Beating the Dow includes profiles of the individual Dow stocks, showing how each has adapted to the modern economy and how each is positioned with reference to the megatrends evident currently. Although all of the Dow stocks are solid long-term investments, Beating the Dow does not involve a “buy and hold” strategy. As John Maynard Keynes once said, “In the long-term we’re all dead.” I don’t know about you, but I prefer a shorter investment horizon.

Part IV of Beating the Dow provides a step-by-step guide to structuring a portfolio of either one, five, or ten Dow stocks (depending on your preference). Your individual portfolio can be self-managed with a minimum of time and expense and has an amazing history of beating the Dow Jones Industrial Average on an annual return basis.

My Beating the Dow-Basic Method incorporates my strategy in its simplest form. Requiring minimal investment, these income-producing portfolios have outperformed the Dow year in and year out. Even in 1987, when October’s Black Monday saw a 508-point drop in the Dow Jones Industrial Average, an all-time record in percentage terms, the Beating the Dow-Basic Method made money for the year with an annual return nearly double that of the average as a whole.

My Beating the Dow-Advanced Method is designed for personal investors with a yen for more than vanilla. It covers more sophisticated strategies and shows the results of combining different selection tools with seasonal market timing techniques to produce outperforming returns, often with reduced risk.

Keep it simple—and make a bundle with Beating the Dow!

CHAPTER 2

Why Common Stocks Are the Best Investment for Accumulating Wealth

BUSINESS IS about risks and rewards. Since stocks represent shares of ownership in a business, you, as a shareholder, share those risks—and those rewards. But business is also about growth. Profitable companies, by retaining what they don’t pay out in dividends, grow bigger. With more capital, they are able to generate increased sales and profits. Over time, the value of shares grows as the business grows. This is just as true of General Motors as it is of a smaller business. It’s easy to forget that the world’s major corporations, with their mind-boggling size and diversity, are businesses.

For these simple reasons, equities—stocks—have historically far outperformed bonds and other fixed-income securities.

One hundred dollars invested in common stocks (as represented by Standard & Poor’s index of 500 stocks) in 1925 would have returned $234,989. Invested in riskier small stocks, it would have grown by $511,565. The same investment in United States government bonds would have earned $4,318 and in Treasury bills (an indication of what a money market fund would have yielded) $1,394. Inflation alone would have increased the value to $814.

With an annual inflation rate averaging 3 percent and an annual total return on the S&P 500 of 12 percent the resultant real return of 9 percent (before income taxes) is impressive evidence of the value of common stocks as a long-term inflation hedge.

A particular stock is as risky as a particular business, but even as most of the best stocks trend upward, they fluctuate in value. The word for that, of course, is volatility, and if you buy high and sell low you can lose money. Combine chronic bad corporate management with bad luck and stocks can become worthless.

STOCKS VS. BONDS AND TREASURY SECURITIES

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A given company’s bonds carry less risk than that same company’s stock. I put it that way rather than categorically because it’s safer to own General Motors stock than Fly-By-Night Bahamian Airline’s junk bonds.

Whereas stock represents ownership and the risks that go with it, bondholders are creditors. If a company goes out of business and sells or otherwise liquidates its assets, it first repays its creditors, then the stockholders get whatever, if anything, is left over.

Stockholders, if they receive income at all, get dividends paid out of surplus earnings. Bondholders get interest, which is a contractual obligation of the company.

Bonds are subject to market risk, like stocks but to a more limited extent. General interest rate levels are always changing; the market prices of fixed-income securities go up or down to adjust the yield (the interest rate as a percentage of the market price) to market rate levels. Bond prices are also affected by supply and demand and by changes in credit quality. But, assuming the issuer is solvent, bonds repay their face value at maturity.

So bonds are generally safer than stocks, but in terms of total return—capital gains plus income—the wealth-building potential of stocks is infinitely greater.

INFLATION

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Inflation is a major argument for owning stocks. Severe enough inflation can cause stocks to lose value, but over the long haul equities have outpaced the inflation rate. Having reached double-digit levels in the 1970s and early 1980s, inflation has been brought under control and currently exists at a nominal rate. Some economists think we could even see a period of deflation. While serious deflation would reduce output and employment and be bad for stocks, a small amount of deflation can actually benefit stocks. That’s because wages tend to remain stable and translate into more spending as prices for goods and services decline.

Bonds and Treasury bills, once issued, do not gain value with inflation. Although inflation expectations are taken into account when the rate of interest is originally determined, these investments become vulnerable to erosion of the dollar’s purchasing power if inflation exceeds expectations. Conversely, marked deflation would benefit bondholders.

REAL ESTATE AND GOLD

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Real estate and gold have traditionally been viewed as inflation protection—"inflation-sensitive” is the buzzword—and are frequently touted as investments offering superior returns to common stocks.

Let’s take real estate first. There are numerous ways to invest in it, from owning it physically to limited partnerships, to real estate investment trusts, to ordinary common stock in companies with real estate activities of various sorts.

I’m not going to say there’s anything inherently wrong with investing in real estate. Immense fortunes have been made (and lost) in real estate. It can be an excellent place to put money if you know what you’re doing and understand the tax ramifications of owning real estate in different ways.

But the charts and graphs you see around that show total returns of real estate investments outperforming common stock deserve another look. They have a special credibility because so many of us are sitting with homes we bought in the 1960s and 1970s that have increased manyfold. What the promoters of real estate investments understandably don’t point out is that the 30 years between the 1960s and the 1990s were an aberration; the major factor in the real estate boom has been the baby boom.

The baby boom has moved through our economic system like a beach ball swallowed by a snake. The “baby boom babies” James Taylor sings about were born after World War II and married and formed families in the sixties and seventies, which is when the real estate boom started. As they gained upward mobility and upgraded their homes during the 1970s to mid-1980s, the boom escalated to a peak. As the nineties got underway, they were midfortyish and starting to think in terms of retirement planning. That this bulging population chose stocks with their record of outperforming other investment alternatives has been the driving force behind the record bull market that is still going strong as the twentieth century draws to a close.

Real estate, continuing a historical pattern, underperformed common stocks between 1960 and the early 1970s, then outperformed common stocks until the late 1980s when the traditional relationships resumed.

Real estate is not a better long-term investment than common stocks.

Gold has always been a popular doomsday hedge, the theory being that it is a store of absolute value whereas securities and currencies have relative value and are subject to loss. It has been true historically that when inflation or other anxieties have dominated market psychology, the price of gold has risen.

Like real estate, gold can be held in various physical forms, as well as by way of mutual funds and other securities.

The performance of gold was most dramatic in January 1980, when high international inflation led by rising oil prices, tension surrounding the American hostage crisis in Iran and civil disorder in o...

Table of contents

• Cover
• Title Page
• Dedication
• Contents
• Preface
• Introduction
• PART I—INTRODUCING THE DOW STOCK SYSTEM
• PART II— THE DOW INDUSTRIAL STOCKS
• PART III— MARKETS AND CYCLES
• PART IV— BEATING THE DOW
• Conclusion
• APPENDIX A—Recent Deletions and Substitutions in the Dow
• APPENDIX B—A Look at the Major Outperformers
• Bibliography
• Index
• About the Author
• Books by John Downes
• Method of Calculating Total Returns
• Copyright
• About the Publisher