Dogs of The Dow: Is This Strategy a Winner?

The Dogs of the Dow is an investment strategy with history.  Michael B. O'Higgins suggested that one should purchase last year’s losers in the Dow Jones Industrial Average.  The methodology is very simple:

Each year investors are to:

1. Find the dividend yields of all Dow Jones Industrial stocks.
2. Invest 10% of their capital in 10 of the highest-yielding companies.
3. Liquidate and select new positions on January 1 of the following year, using the same methodology.

Is it a Winning Strategy?

The Dogs of the Dow has a very simple goal: find stocks that are temporary losers.

The emphasis on dividend yields is important as it:

• Finds yield – Go figure! Investors who purchase the highest-yielding Dow components obviously receive a very good yield for holding individual stocks. Had you purchased the Dogs of the Dow in 2012, you would receive an average dividend yield of 3.95% on your investment capital, more than two times the 10-year US Treasury rate. If all Dow components were to rise in value by the same amount from year to year, naturally it would be the highest-yielding stocks that provide the largest total return.

• Finds depressed stocks – Dividend yield is a function of price and dividends. Thus, if stock prices fall while dividends paid to investors remain stable, the yield rises and the security falls into the “Dogs” category. Ideally, the decline would be temporary, and the Dogs would rise to a higher value by the end of the year.

Dogs of the Dow Historical Performance

Going back 20 years, the Dogs of the Dow rewarded investors with a return of 10.8%. Interestingly, the total Dow Jones Industrial Average rewarded investors with exactly the same return – 10.8% for the last 20 years.

Only one Dogs of the Dow variant has proven to beat the performance of the DJIA – the so-called “small Dogs of the Dow” strategy. The Small Dogs of the Dow requires that investors further concentrate their positions by investing in only 5 of the highest-yielding Dow components with the lowest stock price. The ordinary Dogs of the Dow strategy tells investors to purchase the 10 highest-yielding stocks regardless of the stock price.

The Small Dogs of the Dow returned 12.6% to investors in the last 20 years.

For comparison, $1,000 invested in the S&P500 index would have grown to $6,254. The same investment in the Dogs of the Dow as well as the whole Dow Jones Industrial Average would have grown to $7,776. Finally, the Small Dogs of the Dow would have turned $1,000 into $10,734 in the same 20 year period.

Some Strategies Are Too Simple

The truth is that some strategies are simply too simple. While one could make the case that the Small Dows of the Dow strategy is a winner going forward (just look at past performance!) it ignores plenty of other data and influencer’s of a stock’s price.

Remember, this strategy only focuses on dividend yields. If you look to the 2015 Dogs of the Dow list you’ll find the following names:

AT&T
Verizon
Chevron
McDonald's
Pfizer
General Electric
Merck
Caterpillar
ExxonMobil
Coca Cola

All of these are very large multi-nationals. These certainly are not companies that will grow tremendously going forward, which somewhat explains their high yields. AT&T and Verizon are both returning capital to investors because of limited growth opportunities. The same is true for Pfizer and Merck, which have a solid line-up of pharmaceutical cash flows from years of R&D spending that provide tons of free cash flow.

Additionally, these four names will likely to be on the Dogs of the Dow list for some time to come (they've been there since 2011). Their low stock price relative to dividends may be justified – patent expirations significantly affect pharmaceutical profits, and the explosion of WiFi networks limits future data revenues for the telecommunication networks dependent on cell phone revenues.

Finally, the historical performance of the Dogs of the Dow is in some way influenced by perpetually falling interest rates during the 20 year period. Investors bid down yields as interest rates fall, which boosts stock prices. How much further can interest rates fall going forward as rates are already resting at historic lows?

A More Logical Strategy

All in all, dividends do tend to boost shareholder returns. As cash returned to shareholders can be reinvested in the common stock of a particular company, investors benefit from high-yield companies as a group. Naturally, shareholders would prefer to reinvest a business’s earnings into more ownership of a business rather than see the cash sit in the company’s bank accounts for a paltry .5% annual return.

If dividends strike your fancy, an index like the SPDR S&P Dividend ETF (SDY) might be a better choice. The fund offers investors a spectacular dividend yield of 3.26% and better diversification among the 60 stocks in the S&P High Yield Dividend Aristocrats Index.

That fund has, for the last five years, generated annual returns .34% greater than S&P500 index funds, due mostly to the higher yield.

Readers, what do you think of the Dogs of the Dow investing strategy?  Any strategies you recommend?