Sometimes, the best stock-picking strategies are the simplest ones. The "Dogs of the Dow" theory is certainly simple enough, yet amazingly, this aging strategy still has some proven merit.
What it is
The Dogs of the Dow theory is now 20 years old, though is still as relevant today as it was when Michael O'Higgins unveiled it in 1991.
His approach simply calls for investors to own the 10 highest-yielding stocks among the Dow Jones Industrial Average's 30 constituents, as they are historically the most likely to outperform the index as a group.
While in practice, this approach can be applied any time of the year. But the majority of the time, investors begin to wade into those 10 positions at the end of the year, and/or the beginning of a new year, with plans to hold those picks for the entire 12-month period. And given the calendar, now is the appropriate time to point out the Dow's 10 highest-yielding stocks. Take a look at the table below...
Before anyone rushes out to buy these high-yielding stocks solely based on someone's theory, a reality check may be in order for a couple of reasons.
First and foremost, the strategy implicitly assumes that all 30 of the Dow's constituents value income distribution over growth.
The reality is that some of the Dow's companies have established themselves as dividend-oriented stocks because that's what the market is demanding. McDonald's (NYSE: MCD), AT&T (NYSE: T), and DuPont De Nemours (NYSE: DD) are three heavily-traded stocks that come to mind because they produce income. To expect any of them to outpace the Dow's average return may be an unfair expectation.
A second reason the Dogs of the Dow strategy isn't bulletproof: Some of these stocks are on the Dogs of the Dow list because the only way they would have beaten the Dow would have been if they significantly pumped up their dividend rate.
If they had made forward progress in terms of price, then they'd be off the list. In fact, seven of 2012's "dogs" were on the list in 2010. Eight of 2013's Dogs of the Dow were on the list last year.
Numbers Don't Lie
Still, while the past couple of years may not have yielded much fruit for fans of the approach, over the long haul, there's something to it.
In the past 20 years, the Dogs of the Dow approach has produced an average annual return of 10.8%, versus an average annual return of only 9.6% for the S&P 500. That's not bad, but don't get too excited yet.
See, for the same 20 years, the Dow's average annual return was also 10.8%, meaning the theory did no better or worse than owning all 30 Dow stocks. However, for the past 10-year, five-year and three-year periods, the Dogs of the Dow approach has produced a better average return than the Dow Jones Industrial Average.
Moreover -- and somewhat contrary to the notion that the dogs must work their way off the list for the strategy to work -- in 2010 and 2011, the Dogs of the Dow basket did manage to outperform the Dow even though most of those stocks had been on the list for several years. How? It was indeed a combination of rising dividends and a handful of Dogs that performed amazingly well.
Risks to Consider: Though the theory works more often than not, bear in mind that the Dogs of the Dow theory is deemed to be successful in any given year as long is it outperforms the benchmark. This means even if Dogs collectively lose ground in any given year, as long as it loses less than the Dow Jones Industrial Average, then it's still scored as a win for the approach. It's still a loss, however, for portfolios.
Action to Take --> While it may not make sense to fill out an entire portfolio with the Dogs of the Dow, it's an easy and effective way to place some key blue chips in your portfolio. And, although the upside of doing so hasn't been bulletproof, the idea still been a better than average one. Investors who used the Dogs of the Dow approach nearly doubled the Dow's overall return in 2011, and have topped the S&P 500's average annual return by more than one full percentage point over the course of the past 20 years. That may not be a huge difference, but those nickels and dimes add up over time.