The logic behind the 'Dogs of the Dow'

Long-term performance is more about common sense. Hence the beauty of the Dogs of the Dow.

By MoneyShow.com Oct 26, 2011 3:11PM

By Jim Trippon, Global Profits Alert


There's a history of investor interest in the 30 stocks and their dividends that comprise the Dow Jones Industrial Average ($INDU).


There's even an approach called "Dogs of the Dow," which Michael O'Higgins featured in his book "Beating The Dow." Its relative simplicity struck a chord with many investors.


The approach was to take the 10 highest-yielding Dow stocks, and buy and hold them for a year. At the end of that year, you re-evaluate the group, rebalance it so once again you have the 10 highest yielders, and repeat the process.


The idea is that the high yields correspond to relatively low stock prices for each of the stocks, and that the bad years for these stocks are then followed by good ones.


The premise for profit is that in addition to the dividends, the high yield will signal a relatively low stock price, which is expected to bounce back with price appreciation in the succeeding year while the investor also collects the larger-than-usual dividend. It’s implicitly a value-oriented approach.


How well does this "Dogs" theory work? From 1957 to 2003, the Dogs’ annual return was 14.3%, while the Dow returned 11%. During a shorter span, from 1973 to 1996, the Dogs’ annual return was 20.3% versus 15.8% for the entire Dow.


We realize that picking selected years can provide a best-case scenario, but the method has generally delivered roughly 3% better return for the Dogs than the Dow as a whole.


Of course, with any method the key is whether or not you can use it to generate future profits.

Right now, the 30 Dow stocks feature dividends with current yields ranging from Bank of America’s (BAC) 0.6% to AT&T’s (T) 5.9%. There is a batch of stocks currently yielding in the 2% to 3% range, several that yield less than 2%, and a couple of stocks in the 4% range.


Investors no doubt are aware that Treasury bills now yield in a range from a low of effectively 0% with the three-month bill to 2.95% on the 30-year. Only that, the five-year, and the 10-year yield 1% or more.


So this is the world as it is with yields -- without even mentioning CDs, money markets, and savings and checking accounts.


10 Highest-Yielding Dow Stocks


Currently the 10 top-yielding stocks feature familiar names -- one of the appeals of investing in the Dow stocks, dogs or not -- such as AT&T (T), General Electric (GE), and Travelers (TRV), from a mixture of different industries.


These are blue chips that have a bit of diversity, with telecoms, pharmaceuticals, industrials, consumer-products companies… even a tech stock.


Large-cap slow growers mark the Dow as well as the 10 highest yielders, and with the high visibility of these companies, investors usually feel they know what they’re getting. Again, that’s part of the appeal.


This group averages a yield of 4.09%, certainly far better than the low yields of Treasuries and the like:


CompanyTickerYield
AT&TT5.9%
VerizonVZ5.4%
MerckMRK4.6%
PfizerPFE4.2%
DuPontDD3.6%
General ElectricGE3.6%
IntelINTC3.6%
Johnson & JohnsonJNJ3.5%
Kraft FoodsKFT3.3%
TravelersTRV3.2%


Since the Dogs of the Dow approach began, there have been several ways investors have modified the method. Some have picked the lowest five stocks in the Dow on the basis of share price, while others have picked the four highest stocks on the basis of their share price. Then there’s the Motley Fool approach, which vastly shifted the allocation percentages per stock selected.


There have been further modifications of these methods, and no doubt individual investors have done many more. And while some methods seem to employ an arbitrary methodology, there is evidence that they’ve worked. But this is where the old caution "past performance is no guarantee of future results" might come in as a handy reminder, though.


There are many ways to invest in Dow stocks, either for dividends or a combination of dividends and capital appreciation. Many investors are uncomfortable with an automatic, mechanical selection method such as the Dogs, and want to use their own judgment.


You’ll notice that with the top 10 yield list, some very blue blue chips such as McDonalds (MCD), Procter & Gamble (PG), and others didn’t make the list. Yet these stocks have historically done very well, and investors have done well by them.


If investors are interested in what blue chips have to offer, but aren’t necessarily wedded to the Dow stocks, they can find substitutes -- similar non-Dow stocks which might yield a bit more. Kimberly Clark (KMB) is a consumer-products name that currently yields 3.9%, a bit more than P&G’s 3.2%, while Conoco Phillips (COP) yields 3.8% while Dow component Chevron (CVX) is yielding 3.1%.


There are endless ways to play the Dow dividends, even if you only use them as a starting point for dividend ideas.


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