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Dogs of the Dow

by Charles Rotblut, CFA

Every January, Dogs of the Dow draws attention. The strategy is simple. At the start of every calendar year, sort through the 30 stocks in the Dow Jones Industrial Average and buy the 10 with the highest yields. An equal dollar amount is allocated to every stock and the portfolio is held for the entire year. On the first trading day of the next calendar year, repeat the process.

The idea behind the strategy is that every year a new portfolio will be created. This portfolio is designed to be held for 12 months. Investors should profit by purchasing supposedly out-of-favor stocks whose relative yields suggest their valuations are attractive.

Why January?

The idea of buying the 10 highest-yielding Dow components was popularized by Michael O’Higgins and John Downes in “Beating the Dow” (Harper), first published in 1990. In the 2000 edition, the authors also discussed implementing the strategy at different times, such as in October or mid-December.

In actuality, there may be no benefit to buying stocks on the first day trading day of the New Year as opposed to, say, the day after Thanksgiving. While studies have shown that the markets tend to perform better between November and April than between May and October, last year “selling in May and going away” would have caused you to miss out on a rally that sent the Dow higher by more than 18%.

Can Yield Measure Valuation?

Yield is the amount of dividends paid relative to a stock’s price. The calculation is simple: total dividends expected to be paid over the next 12 months divided by current share price. For example, let’s say a company has historically paid a quarterly dividend of 25 cents per share and is expected to continue to do in the future. If the company’s stock trades at $40 per share, the yield would be 2.5%. (Total expected dividends of $1 per share divided by a $40 share price equals 2.5%.)

Yield can increase if either the stock price falls or the company raises its dividend payment. Obviously, the latter is always preferable.

The theory behind Dogs of the Dow is that a high yield implies the stock is undervalued. This is not always the case as a stock could have a high yield and trade at high multiples of both earnings and book value. Furthermore, though yield is based on dividends expected to be paid over the next 12 months, it is possible for changes made to the dividend policy to not be immediately reflected in the quoted yield. It is also possible for yield to rise on the anticipation that dividends will be reduced or suspended. Thus, a company in financial trouble can temporarily trade with a high yield.

Investors looking at high-yield stocks should always ensure that the company can continue to pay its dividend. It is also important to check the price-earnings ratio or price-book ratio to determine if the valuation is attractive.

Dogs of the Dow Is Restrictive

The biggest problem with the Dogs of the Dow strategy is that it is very restrictive. Just 30 stocks are eligible and investors are required to pick 10 out of this small group solely by using relative yield.

The Dow Jones Industrial Average is intended to measure the performance of U.S. corporations. The portfolio is managed by a handful of editors at Dow Jones. Purposely intended to focus on the most influential corporations, the blue-chip average only holds extremely large U.S. corporations. This means the Dogs of the Dow strategy excludes most U.S large-cap stocks and all mid-cap, small-cap and micro-cap stocks. It also excludes all foreign stocks.

Since the starting universe is so small, the 10 stocks identified by the Dogs of the Dow may be in similar sectors. For example, AT&T (T) and Verizon (VZ) are essentially direct competitors. Should market sentiment turn against telecommunication providers, both stocks would likely underperform.

The reliance solely on yield can also lead to risky investment choices. For example, in recent years, the strategy suggested buying both Citigroup (C) and General Motors (GM). It does not factor in valuation, fiscal strength or business conditions.

A Better Way to Use the Strategy

The Dogs of the Dow approach has historically found some good stock picks. The key is not to buy solely what stocks the strategy recommends, but rather to use the list as a starting point for additional research. Doing so will allow you to benefit from any good stock ideas identified by Dogs of the Dow, while avoiding some of the pitfalls of solely focusing on high-yielding Dow components. Be sure to consider your overall portfolio diversification before buying a Dogs of the Dow stock, since the strategy is so restrictive.

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View an Updated List on AAII.com

Table 1 shows the 10 highest-yielding stocks in the Dow as of press time. You can see an updated list anytime in the AAII Stock Screens section of AAII.com.

In addition, you can also see the latest results for a related screen: The Low Price 5. This is a more aggressive approach that narrows the list of Dow Dogs to those five with the lowest prices.

Related Articles on AAII.com

For more on the Dogs of the Dow approach, you can read these articles on our Web site. Go to the AAII Journal area and select this January 2010 Investor Professor article for direct links to the following.

  • “Blue-Chip Value Investing: The Dogs of The Dow,” by Maria Crawford Scott, July 1998 AAII Journal
  • “Characteristics of Dogs of the Dow Stocks,” by John Bajkowski, August 1998 AAII Journal
  • Dogs of the Dow screen at AAII Stock Screens area, includes an overview of the strategy as tracked on AAII.com, along with a list of passing companies that is updated each month.
Charles Rotblut, CFA is a vice president at AAII and editor of the AAII Journal. Follow him on Twitter at twitter.com/charlesrotblut.