Are The Dogs of the Dow Broken?

Traders and investors are constantly on the hunt for edge in the markets. That said there are a number of different strategies and approaches to the market that work. One strategy that has garnered notoriety over the years has been the Dogs of the Dow.  It was popularized by Michael B. O’Higgins in his bookBeating The Dow.  In the book he shows that the Dogs of the Dow outperformed the market since 1973.

The strategy is simple and straight forward. It entails investors pick ten Dow Jones Industrial Average (DJIA) stocks who have the highest dividend yield.  These ten stocks are selected at the start of the calendar year.

Despite it’s success in the past, the Dogs of the Dow have been a mixed bag, from 1992 to 2011, the strategy matched the average annual return of the DJIA.

The DJIA is composed of large cap “blue chip” companies. That said, the strategy fits in line with value investing.  And since you’re selecting ten out of the 30 Dow stocks chances are good that portfolio will be diversified.

2018 Dogs of the Dow

dogs of the dow

Source: finviz.com

Included in the group are: Verizon Communications Inc (NYSE: VZ); Exxon Mobil Corporation (NYSE: XOM); Chevron Corporation (NYSE: CVX); International Business Machines Corporation (NYSE: IBM); Pfizer (NYSE: PFE); Merck & Co., Inc. (NYSE: MRK); The Procter & Gamble Company (NYSE: PG); General Electric Company (NYSE: GE); The Coca-Cola Company (NYSE: KO); and Cisco Systems, Inc. (NASD: CSCO).

A quick look at the names and you’ll notice that 40% of the portfolio is composed of energy and drug stocks. That said, you’re most likely investing in sectors that got beaten up in the previous year.

For example, lets say a company stock is priced at $100 and and the annual dividend is $3 per share, that’s a dividend yield of 3% Now, let’s say at the end of the year shares of the stock drop 10 points but it maintains the $3 per share annual dividend, the yield jumps to 3.3%

You see, every DJIA stock posts a dividend, and if the stock price goes up the yield drops and vice versa when the stock price declines.

2018 Small Dogs of the Dow

These consist of the 5 lowest-priced Dogs of the Dow.

small dogs of the dow

Source: finviz.com

The 5 lowest-priced stocks are General Electric (NYSE: GE); Pfizer (NYSE: PFE); Coca-Cola (NYSE: KO); Cisco Systems (NASD: CSCO); and Verizon Communications (NYSE: VZ).

So has investing in the strategy worked over the last 5 years?

The Small Dogs of the Dow have returned 18.2%; however, the S&P 500 returned 15.1% and the Dow Jones Industrial Averages returned 13.3% over the same time period.

It makes sense, as the bull market matures, investors try to find value in large cap “beaten up” stocks.  Outside of Coca-Cola, the Small Dogs of the Dow stocks have P/E ratios  of approximately 20 and below.

Should You Buy The Dogs of the Dow

Buying the Dogs of the Dow is similar to being long an index like the DJIA or the S&P 500. You’re buying into blue chip stocks that lagged the previous year.  In a bull market that makes a lot of sense, but during bear markets or when a corporation is under performing the threat of a dividend cut is very real.

For example, in November 2017, General Electric cut its dividend by 50%. Shares of the stock dropped by more than 42% that year.

In addition, if you’re an investor with limited funds you have to be selective on which investment strategy to go with. Some of the largest companies in the world don’t distribute a dividend. Firms like Amazon, Alphabet, Facebook , and Berkshire Hathaway pay no dividend to their investors.

Do you want to invest in growth stocks that better resemble the new economy or do you want invest in companies that have a rich history of stability. A question only you can answer.

The Dogs of the Dow Strategy Is Not Fool Proof

It’s true, the Dogs of the Dow strategy has outperformed the market in the past, but that is no guarantee it will continue to do so in the future. Some recent market dynamics may have altered the strategies effectiveness.

For example, companies are buying back stock.  According to Birinyi Associates, there was $170.8B in stock buybacks during the first month and a half of 2018, a record start.

What do stock buybacks have to do with the Dogs of the Dow?

Stock buybacks are a more flexible way to return money to shareholders. When a corporation buys its company stock, it reduces the number of shares that are publicly traded. So, if a company retains the same profits from the previous quarter, the earnings per share will increase because of the stock float reduction.

That said, if shares of the stock price rise investors can defer capital gains. On the other hand, dividends are taxed as ordinary income.

Of course, there is a downside to stock buybacks. A stock buyback can artificially boost earnings and the price of the company stock.  Now traders might love this, but investors might not benefit as much in the long-term.

Bottom Line

The Dogs of the Dow is a strategy consisting of buying the ten DJIA stocks with the highest dividend yield. The selection is made based on the close of the previous year. You won’t necessarily see the same stocks on the list every year, so you’ll have to make the adjustments if you want to follow it.

That said, buying into a company because it has a high yield is not a good stand alone reason to be long. You’ll have to do more due diligence than that. Consider looking into fundamentals; the prospects for the sector; analyst reports;  and guidance from the company.

Now, if you’re looking to trade for a year than you’ll also want to look at charts and do some technical analysis. Even if you’re not much of a chartist, it still helps when you’re trying to decide your entries and exits. As well as, where to set your stop levels and profit targets.

The Dogs of the Dow is not the holy grail of trading. However, its an interesting strategy for swing traders interested in value plays.

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