Trouncing the DOW

I do not expect Kenneth Lee’s Trouncing the DOW to be as successful in the future as it has been in the past, on paper. Yet, it is a winning strategy. It is likely to outperform the market consistently. His approach bears a strong resemblance to (my understanding of) Geraldine Weiss’s dividend strategy, which has proved itself to be among the best. What is more, it makes sense.

If you limit your selections to high quality companies and buy those that are out of favor, you are likely to do well. Admittedly, a few companies will sink further into oblivion. But a large majority will recover and do well. At times, a recovery can involve nothing more than a change in public perceptions.

Kenneth Lee assures high quality by limiting his selections to the thirty companies in the Dow Jones Industrial Average. He uses ten year averages from data extracted from Value Line.

1) His averages are high price, low price, book value and return on equity. He does not average single year ratios such as price to book value.

2) He selects the latest year’s return on equity. He divides this by the ten year average of returns on equity to form a scale factor.

3) He selects the latest book value.

4) He calculates price extremes using his averages and the latest year’s return on equity. For example, the high price extreme equals the [(average high price)/(the average book value)]*[(the latest year’s return on equity)/(the average return on equity)]*[the current book value].

5) He introduces a few additional screens to avoid disasters. One of them is a minimal earnings growth rate. He requires earnings to grow (in nominal dollars, not adjusted for inflation) at least ten percent per year.

Kenneth Lee cautions against investment mistakes such as overactive buying and selling, which would generate excessive transaction costs.

Notice that (book value)*(return on equity) is very similar to (earnings). In a sense, Kenneth Lee is estimating high and low price to earnings ratios based on a decade’s worth of data. Evidently, Kenneth Lee considers book value and return on equity more reliable (better choices) for establishing price limits.

Notice how similar this is to Geraldine Weiss’s approach, except that she focuses on dividends.

Notice that “do it yourselfers” can combine and extend such measures. Traditional measures would be based on earnings, cash flow, book value and dividends. Sales growth is another good choice provided that sales generate earnings. You should limit your selections to high quality companies. You would establish historical price limits based on ten years or so of data. You would purchase when the current price falls below the lower historical limit. You consider selling when the current price rises above the upper historical limits. [If the current price rises far above the upper historical limit, you would sell regardless.]

Have fun.

John Walter Russell
December 26, 2006