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Friday, December 20, 2013 - 14:30

Which Dow 'Dogs' Are Poised To Beat The Pack In 2014?

Friday, December 20, 2013 2:30 PM

It's been a good year for stocks that make up the Dow Jones Industrial Average, as 28 of the 30 components have risen in value (with IBM (NYSE: IBM) and Caterpillar (NYSE: CAT) as the only laggards).

And it's been an even better year for the Dogs of the Dow. These are the 10 stocks that had the highest dividend yields when the year began, and this group has gained 25.5% in 2013 against a 24% gain for the broader index, according to DogsoftheDow.com.

To be sure, that is not a significant level of outperformance. History has shown that this approach works best in so-so markets, and is not primed for relatively better gains when then market slumps badly or soars sharply. Considering the market has fared very well in 2013, 2014 gains may be much more muted, and if so, the Dow of the Dogs approach may again lead to sharp outperformance.

Why Hated Is Good
The appeal of this approach is self-evident. High dividend yields are a sign that a company is out of favor. And it's a lot easier for a stock that has no supporters to win new converts than it is for a stock that is already much-loved by the crowd.

Take Hewlett-Packard (NYSE: HPQ) for example. By the end of 2012, this stock was so despised that it entered into the group of Dow Dogs for the first time ever. Even though Hewlett-Packard remains quite troubled, investors stopped expecting even deeper misery, which has paved the way for a 95% gain thus far in 2013.

Using this "out of favor" approach, you could single out IBM and Caterpillar as the best rebound candidates in the Dow for 2014, though that's too simplistic. IBM's troubles run too deep, as I noted in a recent column. In contrast, Caterpillar still faces much better days ahead. The company's exposure to mining and construction is a big drag right now, but should be a deep virtue in the years ahead.

At year's end, it's helpful to look at the Dow Dogs for the year ahead, to get a sense of which stocks have been out of favor, and or simply which Dow components sport the juiciest dividends right now.

The first item that jumps out at you is just how tough it is for major corporations to boost sales these days. Only Microsoft (Nasdaq: MSFT) is poised for sales growth above 5% this year. This is the first time that Microsoft and Cisco Systems (Nasdaq: CSCO) have ever been Dow Dogs, though that's partly attributable to robust dividend growth at these firms. Indeed, it's these two firms, along with chip giant Intel (Nasdaq: INTC), that have the cash-rich balance sheets to fuel further robust dividend growth.

Yet there is another stat of these Dow Dogs that also deserves mention. Great yields aren't what they used to be. Note that Microsoft and DuPont (NYSE: DD) make this list with dividend yields of just 3%. A year ago, Chevron was in the tenth slot with a 3.5% yield, and you have to go back to 2007 to find the last time any Dow Dog yielded less than 3% (JPMorgan Chase (NYSE: JPM) had a 2.7% yield at the end of that year).

The key takeaway: Robust dividend growth has been more than offset by rising stock prices. Trouble is, for many companies, dividend growth appears to be cooling. As I noted a few weeks ago, "the outlook for dividend growth in the S&P 500 is likely to be much more muted in coming years, with earnings per share (EPS) growth -- not rapidly rising payout ratios -- becoming the prime determinant." So let's look at the group of 2014 Dow Dogs again, this time in the context of projected 2014 profit growth.

Using EPS growth as a proxy for dividend growth, then both Verizon (NYSE: VZ) and AT&T (NYSE: T) hold great appeal, though I'd choose Verizon over AT&T, thanks to its superior execution in the wireless services industry. Indeed, short sellers continue to aggressively target AT&T with the short position now standing above 130 million shares, which makes it the second most heavily shorted stock on the New York Stock Exchange. That's far above the levels of short interest I noted just a few months ago.

Another reason to be dubious of both Verizon and AT&T: Their payout ratios are out of whack. According to Thomson Reuters, each of these firms has doled out more funds in dividends over the past 12 months than the cash flow to support them.

Payout ratios also explain why it's the cash-rich tech stocks you need to strongly consider for the year ahead. Cisco, Microsoft and Intel have so much cash, and generate such high levels of free cash flow, that they are positioned to boost their payout ratios much higher (or boost share buybacks which are equally beneficial).

Although Microsoft is posting better operating fundamentals right now, I actually prefer Cisco Systems among this group, thanks to its industry-leading positioning in so many areas that will eventually lead to solid top and bottom-line growth. Cisco has been a very frustrating stock for its supporters (myself included), but it's hard to ignore the fact that the balance sheet is bulletproof, profit margins remain solid, and management's long-term track record is outstanding.

Risks to Consider: Compared to a year ago, the dividend yields on the Dow Dogs are noticeably lower, and rising interest rates could make their yields comparatively less appealing.

Action to Take --> Not all Dow Dogs are equally appealing. The tech giants, with their low payout ratios and high cash balances, are the only ones capable of solidly growing yields.

P.S. Worried about finding the best dividend yields in 2014? In our latest Top 10 Stocks report, you'll find one "wide-moat" company that has raised its dividend over 460% since 2004. Another dominates its market... has increased dividend payments 104% since 2008... and has returned 131% since it went public just over four years ago. You can learn more about these 10 stocks, including several names and ticker symbols here.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC owns shares of T in one or more of its “real money” portfolios.