Score one for the “Dogs.” A look at the 2012 performance of the “Dogs of the Dow,” which are the 10 stocks in the Dow Jones Industrial Average (DJIA) with the highest dividend yield, now reveals an impressive run. 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 stocks in the Dow in the next 12 months.

As a group, these 10 stocks rose an impressive 8.3% so far this year, which is five full percentage points ahead of the broader Dow Jones Industrial Average. In fact, toss out these 10 “Dogs,” and the rest of the DJIA’s 20 stocks are on track to finish the year flat.

Another plus: Add in these Dogs’ solid dividend yields (which ranged from 3 to 6%), and the entire group has delivered double-digit gains in terms of total return thus far in 2012. Hats off to Merck (NYSE: MRK), AT&T (NYSE: T), GE (NYSE: GE) and Kraft Foods Group (Nasdaq: KRFT), for delivering total returns exceeding 20% in the same period. (Note that Kraft was split into Kraft Foods Group and Mondelez International (Nasdaq: MDLZ) earlier this year, and the returns represent continued stakes in each firm).

A Solid Year for the Dow’s Dogs

Why did these stocks fare so well in 2012? Because investors continue to gravitate toward income-producing stocks, especially while fixed-income investments such as bonds and certificate of deposits are offering such paltry yields of 2%.

Taken a step further, the top five stocks in this group have returned nearly 19% in 2012 (when capital appreciation and dividend yields are included), which is quite remarkable at a time when the major averages are drifting back toward breakeven for the year.

What about 2013?
The question for investors is whether this approach can beat the market again in 2013. Before answering that, let’s look at the current crop of Dow Dogs (though this group may change a bit before now and year’s end).

The coming Dow Dogs portfolio

Of course, to make this group, you often have to be out of favor. For example, McDonald’s (NYSE: MCD), Hewlett-Packard (NYSE: HPQ) and Chevron (NYSE: CVX) weren’t on this list a year ago, though their negative returns thus far in 2012 have pushed up their yields. Conversely, a strong year for companies such as GE means they’re not welcome in this club for 2013.

And this is exactly what highlights the unusual approach for this investment strategy. The Dogs of the Dow basket of stocks can pay off if underperformers start to claw back and deliver gains in the year ahead. 

If you look at it another way, these stocks can post robust gains if investors perceive them as solid “dividend growers.” In recent years, there’s been a clear interest in stocks that tend to support steadily rising payouts. So how does this coming crop of Dow Dogs fare when it comes to dividend growth? Here’s what their average annual dividend growth rate has been during the past four years…#-ad_banner-#

McDonald’s has managed to deliver very impressive dividend hikes in recent years, but the fastest-growing dividends are mostly coming from the high-tech field. Intel (Nasdaq: INTC) and Hewlett-Packard have boosted the payout at a roughly 15% annual clip, while companies like Microsoft (Nasdaq: MSFT), Cisco Systems (Nasdaq: CSCO) and Apple (Nasdaq: AAPL) are becoming dividend stars as well. 

So perhaps we should suggest a new twist on the Dogs of the Dow Theory: Focus on the components in the Dow that sport the highest yields and the fastest-growing dividends. The five companies in this group are: Intel, Hewlett-Packard, McDonalds, Johnson & Johnson (NYSE: JNJ) and Chevron (NYSE: CVX).

Risks to Consider: The Dogs of the Dow approach has been a solid one in 2012, but this group has also underperformed the rest of the pack in certain years. Yet over the long haul, it has tended to deliver superior returns. 

Action to Take –> We’ve got six more weeks to see how this race finishes, but the Dogs of the Dow’s five-percentage-point lead appears undefeatable at this point. Toss in the income they’ve produced, and the total return has been especially notable. The appeal of this approach is that even if these stocks don’t outperform, their high dividend yields should keep them from tanking in a tough market, especially since their payout still exceeds most other fixed-income investments.