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Good Dog!

Investing in stocks considered the dogs of an index won't have you chasing your tail.
October 1, 1997
URL: http://www.entrepreneur.com/article/14692

Even to the most unaware and uninitiated, this year is the year of the stock. As the Dow Jones Industrial Average (DJIA) and the Standard & Poor's 500 (S&P 500) Index effortlessly vault through record after record, investors in search of a bargain have begun to wonder if there is anything left to buy low and at what price should they sell high? In a market full of greyhounds, how do you find the laggards? They say every dog has its day, and for value-oriented investors, the solution can be found as close as the nearest pound . . . by investing in some "dogs," that is.

We're not talking about adding just any old mongrel to your portfolio. The idea is to buy the 10 DJIA stocks that currently sport the highest yields--the "dogs of the Dow." The trick is to buy equal amounts of these 10 stocks and hold them for a year. After 12 months, you'll reassess your holdings, replacing lower-yielding stocks with those that are the current year's dogs.

These stocks are referred to as "dogs" because although the underlying companies are well-established and have high dividend yields, they have fallen out of favor and their prices have been driven down. It is hoped that although they are beaten down at the moment, they will enjoy a turnaround and do better in the future. Since we wrote about it two years ago, investors have poured hundreds of thousands of dollars into the Dow Dividend Strategy (DDS), as it is known, effectively forcing themselves to buy low and sell high. Of course, there is no assurance, nor does this imply, that the stocks are being bought at the bottom and that they'll move up from there.

Through the DDS, investing in the dogs of the Dow allows investors to focus on household-name companies with long histories. By emphasizing the 10 highest-yielding stocks rather than the 10 DJIA stocks with the highest dividends, the DDS aims for enhanced total return from both capital gains and dividends. How does it work? Consider that yield is an inverse indication of a stock's popularity. As a stock's price rises, its yield falls. Look at it this way: Yield=annual dividend/stock price.

If ABC Corp. pays a $10-per-share annual dividend and the share price is $50, ABC's yield is $10 divided by $50, or 20 percent. If the share price of ABC rises to $100 while the dividend remains the same ($10), the new yield is 10 percent. At first glance, the drop in yield seems negative, but what has actually happened is a bonanza: capital gains and income, a pedigree worth having. Compared to other investment strategies, investing in the Dow's dogs is easy.

A variation on the theme, the Low 5 Dow Dividend Strategy limits the portfolio to the five highest-yielding stocks. Investors choose the five lowest-priced stocks of the DDS on the day their portfolio is established. Again, the portfolio is held for a year and all dividends are reinvested. Whichever strategy is selected, ideally investors continue it, adjusting positions annually for the life of their "pet," for at least one complete market cycle of three to five years. Both strategies are considered to be long-term strategies, which should be made with the understanding of the risks associated with common stocks.

Champion Bloodlines

Both the Top 10 and the Low 5 DDSs have historically rewarded investors. And while past performance is no guarantee of future returns, in the period beginning January 1977 through the last trading day of 1996, assuming total return proceeds were reinvested at the beginning of each calendar year, the 20-year record puts the DDS ahead of the DJIA with an average compounded annual total return of 17.62 percent vs. 14.25 percent for the full 30 DJIA stocks.

Surprisingly, the Low 5 provides an even higher average compounded annual return for the same 20-year period--20.18 percent. Put it this way: Hypothetical investors who put $10,000 in the Low 5 DDS at the beginning of 1977 and followed the strategy annually could have seen their investment grow to more than $395,000 in 20 years, compared to the more than $256,000 for the DDS Top 10 portfolio and the nearly $144,000 for the full DJIA portfolio. (Results exclude the effect of state and federal taxes, commissions, and sales charges.)

There are two forces at work behind the returns of the DDS strategies. The first is the effect of yield. Dividends paid by the companies in the DJIA have increased in 60 of the past 68 years, and this accounts for about 40 percent of the overall return. Second, compounding these dividends accounts for 10 percent of the improved total return. The success of the DDS offers another reason why time in the market is more important than timing the market.

A Different Breed

The strategy of selecting the stocks with the highest yields from a well-known index isn't limited to the DJIA. By back-testing several variations of the high-dividend strategy, investors can uncover a plethora of investment options. Whether you're looking overseas for diversification or prefer to keep your investments stateside, there is more than one way to skin a cat.

First, for landlubbers, consider a strategy using a subset of the widely recognized S&P 500 Composite Stock Price Index. The S&P 500 features utility, financial, transportation and industrial stocks. The S&P Industrial Index, a subset of the S&P 500, includes only highly capitalized industrial stocks. While many permutations can be made from these lists of companies, here's one strategy investors have found to be productive:

1. Begin with the S&P Industrial Index (approximately 380 stocks).

2. Eliminate DJIA stocks (approximately 350 stocks left).

3. Eliminate companies with S&P quality rankings less than "A" (75 left).

4. Rank stocks by market capitalization, eliminating the bottom 25 percent (55 left).

5. Rank remaining stocks by dividend yield and invest equal amounts in the 15 with the highest yields.

As with the DDS, the portfolio is held for a year and then rebalanced.

Hypothetical results from back-testing reveal interesting results. From 1972 through the end of 1996, this strategy would have beaten the S&P Industrial Index in 16 of the past 25 years and the DJIA in 14 of the past 25 years while posting only three down years. The average annual return for the period from 1972 to the end of March 1997 is 17.49 percent vs. 12.76 percent for the DJIA and 12.34 percent for the S&P 500. Since it holds none of the same stocks as the DDS, this strategy nicely complements the DDS. Keep in mind, investors cannot invest directly in a specific index.

Feel like going international? The same type of strategy used on the components of the DJIA and S&P 500 indices can be used on foreign indices as well. But remember that foreign investments are subject to additional risks, such as currency fluctuation and social, political and economic uncertainty.

Portfolios taken from the Financial Times Stock Exchange (London), Hang Seng (Hong Kong) and Nikkei (Tokyo) indices have shown interesting results when back-tested for various periods. The Financial Times Top 10 have beaten the underlying index of 30 stocks 15 out of the last 20 years and three out the last five years. Back-tested performance to 1977 shows an annualized total return for the strategy of 24.08 percent vs. 16.51 percent for the Financial Times index through December 31, 1996.

The Hang Seng Top 10 has beaten its underlying index in 10 of the last 18 years; and back-tested performance to 1978 shows an annualized total return for the strategy of 22.71 percent vs. 21.65 percent for the Hang Seng index through December 31, 1996. Back-testing performance for the Nikkei from 1977 through December 31, 1996, shows a return of 20.13 percent for the strategy vs. 13.39 percent for the index.

If you're thinking of adopting a pet or two, make sure you've got room for the "dogs" you select before you invest in a leash and collar. Investors can buy shares in individual issues and rebalance positions annually themselves. Though these dogs don't need a big yard or lots of exercise, often the best place to put them is in a tax-deferred account such as an IRA or a retirement plan. That way, when the portfolios change, capital gains and dividends won't be taxable. And that may be one way to win best of show.

Lorayne Fiorillo is a financial advisor and first vice president at Prudential Securities Inc. For a list of the current "dogs of the Dow," send a self-addressed, stamped envelope to her in care of Entrepreneur, 2392 Morse Ave., Irvine, CA 92614.