A Fresh Look at the Dogs of the Dow

The coming year marks the 20th anniversary of the first use of “Dogs of the Dow” as an investment strategy, which focuses on the 10 highest-yielding stocks in the Dow Jones Industrial Average (DJIA). In theory, these high yielders have been oversold (as the share price falls, the dividend yield goes up) and are most likely to outperform the rest of the Dow stocks in the next 12 months.

In its first decade, the Dogs of the Dow approach yielded impressive returns from 1991 through 1996, though it couldn’t keep up with the scorching results posted by the major indexes in the late 1990s bull market. In the first half of the last decade, though, the Dogs of the Dow approach proved its mettle: By the end of 2004, $1,000 invested using this theory would have returned +24% while the broader S&P 500 and DJIA were roughly flat. Yet in the next five years, the indexes caught up (or said another way, the Dow Dogs portfolio fell back in line with all other underperforming stocks in the 2008 market downdraft).

The Dow Dogs vs. the indexes since the end of 1999 (total return)

The key takeaway in the last 15 years is that this approach works well in an era of slow growth and weak market returns, but doesn’t fare as well in an era of higher economic growth and more robust market returns. So if you expect the U.S. economy to post lackluster results in the next few years, which I suspect it may, you might want to give the Dogs of the Dow a fresh look.

Buy the basket or cherry pick?
The above-cited performance results were generated by a passive investment strategy that holds all 10 Dow Dogs. You could also look to try and cherry pick the stocks that you think have the greatest chance for capital appreciation. For example, Verizon (NYSE: VZ), AT&T (NYSE: T), Merck (NYSE: MRK) and Pfizer (NYSE: PFE) offer very juicy dividends, but organic growth at each of these companies is quite anemic and it’s hard to see how investors will suddenly find these stocks to be more appealing.

The remaining Dow Dogs appear to offer better paths to capital appreciation. DuPont (NYSE: DD) and Chevron (NYSE: CVX) would both clearly benefit from rising global economic activity that pushes up demand for energy and industrial chemicals. And Johnson & Johnson (NYSE: JNJ), McDonalds (NYSE: MCD) and Procter & Gamble (NYSE: PG) all would benefit from continued development of emerging market economies, especially if the dollar eventually resumes its secular downward move.

Yet it is Kraft (NYSE: KFT) that may be the most compelling name in the group, thanks to a radical re-jiggering of its product lineup that should unlock shareholder value. Kraft has been selling some units while acquiring others, most notably confectionary firm Cadbury, which was acquired at the start of 2010. The net result is that Kraft’s current range of products have much more resonance with consumers compared to a few years ago, which allows management to more easily push through price increases if necessary.
Kraft, which has more than 50 distinct brands with at least $100 billion in sales (11 of the brands, such as Nabisco, Oscar Meyer and Maxwell House, have more than $1 billion in sales). The firm now derives roughly 50% of its revenue from abroad and 25% from emerging markets. And since Kraft’s product lines are more likely to be segment leaders these days, management doesn’t need to play defense as much in terms of promotional activity. “We continue to see Kraft as a much improved company. Results are coming in more consistently and the forward outlook is strong,” note the analysts at Citigroup, who predict shares will rise from a current $30 to $40.

Analysts at UBS are similarly bullish, predicting that 2011 results will be characterized by emerging market growth, nearly $1 billion in cumulative cost cuts at Cadbury, and steady price increases in North America. In the next few years Kraft is expected to find additional ways to get better results from promotional spending, shed the lowest-margin divisions and eventually use that cash flow to boost its dividend yet higher.

Action to Take –> The Dogs of the Dow approach hasn’t been discussed much in recent years, but it worked quite well in the first half of the last decade when the U.S. economy was mired in a low-growth slump. But 2011 looks like a repeat of the period from 2001 through 2003, so the time may be ripe again for you to consider this strategy.