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    Dow Dogs Make Their Mark With Pure Mechanical Approach

    by Wayne A. Thorp

    Regular readers of these stock screen articles know that we discourage viewing the results of any stock screening methodology as a “buy” or “recommended” list. Instead, we view the list of passing companies of any approach as a starting point, not the finished product. However, some quantitative approaches, by their nature, are purely mechanical—the final list of companies is what you buy. One such approach is the Dogs of the Dow, which was popularized in the book, “Beating the Dow” by Michael O’Higgins and John Downes (Collins, 2000).

    The “dogs” are stocks among the 30 Dow Jones industrial average companies that have the highest dividend yield (a company’s indicated dividend payment for the upcoming year divided by the current share price). These companies, on average, have the financial position, resources, and visibility to see them through any financial storms.

    The Dow Dogs methodology emphasizes out-of-favor Dow stocks that are possibly underpriced relative to others, as indicated by high dividend yields. Often, this is the result of the market’s overreaction to unfavorable short-term developments or business cycles. Over time, O’Higgins and Downes argue, the stocks will regain a value that reflects the actual underlying risk. Overall, the philosophy combines a strategy of investing in high-quality stocks with a contrarian approach.

    The purely mechanical nature of the Dogs of the Dow approach forces strict investor discipline, and requires no investment decision-making expertise—a highly appealing strategy to many individual investors, particularly market neophytes.

    The Dogs of the Dow Screen

    There are actually two Dogs of the Dow screens, both of which we track using Stock Investor Pro, AAII’s fundamental stock screening and research database program.

    The “original” Dogs of the Dow screen looks for the 10 Dow Jones industrial average stocks with the highest dividend yield.

    The Low Priced Five Dogs of the Dow approach—sometimes also referred to as the Small Dogs of the Dow, the Puppies of the Dow, or the Flying Five—starts with the 10 Dogs of the Dow stocks and takes the five with the lowest price. This approach is designed to take advantage of what O’Higgins and Downes believe is the tendency of less expensive stocks to be more prone to greater percentage price moves. We detail the screening criteria used for both of these screens on page 29.

    Screen Performance

    Each month, AAII.com lists the companies passing the Dogs of the Dow and Low-Priced Five screens and tracks the performance of these stocks in hypothetical portfolios.

    Compared to most of the other screening philosophies we track, the Dogs of the Dow screens are laggards in terms of performance. However, both saw a resurgence last year and posted impressive returns:

    • The Dogs of the Dow approach gained 26.8% in 2006, and
    • The Low-Priced Five methodology was up 34.9%.

    Overall, however, the performance has not been quite so good. While the Dogs of the Dow Low Priced Five screen has managed to outperform the Dow Jones industrial average and the S&P 500 indexes since the start of 1998, the Dogs of the Dow approach has basically matched the S&P 500 over the same period.

    Figure 1.
    Performance of
    Two Dogs of the
    Dow Screens
    CLICK ON IMAGE TO
    SEE FULL SIZE.

    Figure 1 shows that the Dogs of the Dow approach generated a cumulative return of 45.2% from the beginning of 1998 though the end of February 2007, while the Low Priced Five screen was up 86.5% and the S&P 500 gained 45% over the same period. However, keep in mind that the results do not include dividends (nor do they include various trading costs or taxes). The current average dividend yield is 3.7% for the Dogs of the Dow and is 3.9% for the Low Priced Five Dogs; shareholders of these stocks would actually have a return that is higher by approximately these amounts, annually.

    Profile of Passing Companies

    The characteristics of the stocks currently passing the Dogs of the Dow and the Dogs of the Dow Low Priced Five criteria are presented in Table 1.

    According to the Dogs of the Dow approach, identifying undervalued Dow stocks is most effectively done by examining dividend yield. It is similar to other popular valuation measures such as price-earnings ratios and book value per share, with high dividend yields indicating a potentially undervalued stock. However, price-earnings ratios and book value are subject to distortion due to short-term earnings fluctuations as well as different accounting interpretations in book value and reported earnings. Dividend payments, in contrast, tend to be more predictable and not subject to differing accounting interpretations, offering a more stable measure to relate to share price. Relative to exchange-listed stocks, both sets of passing companies have lower median price-earnings ratios—17.2 for the Dogs and the Dow and 18.3 for the Dogs of the Dow Low Priced Five, versus 19.4 for exchange-listed stocks.

    Given the “mature” nature of the Dow Jones industrial companies, it is probably not surprising to see that the Dow Dogs have median historical earnings per share growth rates—5.5% for the Dogs of the Dow and 4.7% for the Low Priced Five stocks—that are roughly a third of that of exchange-listed stocks, which is 15.0%. They also lag far behind the typical exchange-listed stock in terms of forecasted earnings growth—whereas exchange-listed stocks have a median estimated earnings growth rate of 14.2%, the Dogs of the Dow stocks are at 7.8% and the Low Priced Five stocks are at 6.0%.

    Dow stocks tend to be among the largest publicly traded companies. The median market capitalization is $45.1 billion for the Dogs of the Dow and $80.1 billion for the Low Priced Five. In comparison, the median market cap for all exchange-listed stocks is $482.5 million.

    The 10 current Dogs of the Dow stocks have outperformed the S&P 500 index by 5% over the last 52 weeks. Over the same period, both the Dogs of the Dow Low Priced Five and the typical exchange-listed stock have underperformed the S&P 500—by 3% and 2%, respectively.

    Given the fact that the Dow Dogs methodologies pull from a very small universe—the 30 companies of the Dow Jones industrial average—and that the criteria utilized (for these companies) are relatively stable, we find relatively low turnover in the screens. In fact, the Dogs of the Dow screen, with its average monthly turnover of 6.7%, has the lowest turnover among all the screens AAII tracks. The 15.3% average monthly turnover for the Low Priced Five approach is also among the lowest. Note that these backtesting results assume monthly rebalancing, while the Dows of the Dow approach calls for annual rebalancing.

    Table 1. Dogs of the Dow Portfolio Characteristics
    Portfolio Characteristics (Median) Dogs of the Dow Screen Dogs of the Dow--Low Priced 5 Screen Exchange-Listed Stocks
    Price-earnings ratio (X) 17.2 18.3 19.4
    Price-to-book-value ratio (X) 2.9 2.2 2.2
    Dividend yield (%) 3.7 3.9 0
    EPS 5-yr. historical growth rate (%) 5.5 4.7 15
    EPS 3-5 yr. estimated growth rate (%) 7.8 6 14.2
    DPS 5-yr. historical growth rate (%) 7 5.6 0
    Market cap ($ million) 45,108.40 80,078.50 482.5
    Relative strength vs. S&P (%) 5 -3 -2
    Monthly Observations
    Average no. of passing stocks 10 5  
    Highest no. of passing stocks 10 5  
    Lowest no. of passing stocks 10 4  
    Monthly turnover (%) 6.7 15.3  
    Data as of March 9, 2007.

    Current Companies

    Yield is the cornerstone of the Dow Dogs approaches. The 10 stocks currently passing the two Dow Dogs screens are listed in Table 2, ranked in descending order by current dividend yield.

    As of March 9, 2007, the “hurdle” yield for the Dow Dogs was 2.9%, shared by E.I. du Pont and Coca-Cola Company. The median yield for the Dogs of the Dow is a healthy 3.7%.

    The five companies in the Dogs of the Dow screen that also have the lowest current stock price are listed in the Dogs of the Dow Low Priced Five screen. Among these companies, the median dividend yield is 3.9%.

    The typical exchange-listed stock does not pay a dividend. Pfizer Inc., the international pharmaceutical firm, has the highest dividend yield among the companies in Table 2, at 4.6%. Looking at the growth in dividends per share (DPS) for both groups of companies, we find that the median growth rate is 7.0% for the Dogs of the Dow and 5.6% for the Low Priced Five companies. Citigroup Inc. has been able to increase its dividends by 26.7% on an annualized basis over the last five years. On the other end of the spectrum is General Motors. In a move to cut costs amidst a mounting financial crisis, the company announced last year that it was cutting its annual dividend in half, from $2.00 per share to $1.00 per share. On an annualized basis, GM has seen its dividend decline by 12.9% over the last five years. Despite the significant dividend cut, General Motors still has a dividend yield of 3.2%.

    Interestingly, nine of the 10 companies in Table 2 have five-year dividend growth rates that exceed their five-year growth rate in earnings per share. The sole exception is Verizon Communications, which has an earnings per share growth rate of 72.4% and a dividend growth rate of 1.0%.

     

    Conclusion

    The Dogs of the Dow approach offers a purely mechanical screen that focuses exclusively on well-known companies and purchasing them when they become undervalued relative to each other.

    The approach is particularly useful for individuals who prefer strict guidelines for buying and selling, who want a steady source of dividend income, and who lack the financial expertise required for more in-depth stock analysis. It is less useful for investors primarily seeking growth and who are trying to limit annual taxable income.

    Like all stock investing strategies, the Dogs of Dow screens carry risks. Given the small number of stocks in which both the Dogs of the Dow and Low Priced Five invest, you are more susceptible to price movements by individual stocks. This is especially the case if you are only investing in the Dogs of the Dow Low Priced Five stocks.

    Likewise, the Dogs of the Dow approach has lagged the Dow Jones industrial average and the S&P 500 over the last several years. Therefore, you would have been better off investing in an index fund over this period.

    However, as 2006 showed, there are times when it will flourish.

       What It Takes: Dogs of the Dow Screening Criteria
    Dogs of the Dow
    • Only the 30 companies that make up the Dow Jones industrial average are eligible
    • Of the companies that make up the Dow Jones industrial average, the 10 with the highest dividend yield are included
    Dogs of the Dow—Low Priced 5
    • Of the 10 companies that make up the Dogs of the Dow, the five with the lowest stock price are included


    Wayne A. Thorp, CFA, is financial analyst at AAII and editor of Computerized Investing.


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