Why Successful Investors use the Dogs of the Dow Strategy

The beginning of a new year is the time when investors take a look at their portfolios and try to guess which stocks will make them the most money in the coming year. Some spend countless hours, even weeks analyzing previous trends and historical performance, while others spend about an hour and pick the Dogs of the Dow.

The “Dow” is of course the Dow Jones Industrial Average (DJIA) and it is composed of 30 blue chip companies that are tracked by professional traders to get a feel for how the broad market could be trending. The “Dogs” are the 10 highest-yielding stocks of the DJIA. The objective of using this strategy is to get more dividend income and typically stock yields rise when stock prices fall. The Dogs of the Dow strategy capitalizes on this phenomenon. Because of their less than dynamic performance in the previous year, these Dogs hold a higher possibility for growth.

Who Let the Dogs Out?

The man responsible for unleashing the Dogs of the Dow is financial writer Michael O’Higgins. He first introduced this concept in 1991 as a way for investors to rebalance their portfolios. This mechanical strategy proved to be effective, especially for those investors who had little or no time to constantly analyze emerging opportunities.

O’Higgins based this strategy on the idea that blue chip companies do not alter their dividend to reflect trading conditions and so the dividend is a measure of the average worth of the company. On the other hand, the stock price fluctuates through the business cycle.

He felt that this should mean that companies with high yields (i.e. high dividend relative to price) are near the bottom of their business cycles and they are likely to see their stock prices increase faster than low yield companies. Therefore, investors of these Dogs of the Dow are reinvesting in high-yield companies that should out-perform the overall market.

Online financial planning websites such as stockmarketinvestors.com have noted that a high dividend yield usually suggests both that the stock is oversold and that company management believes in its prospects and is willing to back that up by paying out a relatively high dividend. Investors are thereby hoping to benefit from both above average stock price gains as well as a relatively high quarterly dividend.

Running With the Big Dogs

In an article about reasons for Dogs of the Dow continued popularity, the Wall Street Journal noted that this strategy has a “significant following that never seems to abate, due in part to its strength during certain periods. It outperformed during the bear markets of 2000 to 2002, and it beat the broader market for 2010. The Dogs stocks climbed 15.5 percent for this past year, excluding dividend income, surpassing the Dow’s 11 percent increase.”

The Dogs strategy will likely have even more fans in the coming year because of the uncertainty in the economy and the low yields in the Treasury market. Since the Bush-era tax cuts were extended before the end of 2010, the tax rate on dividends will stay low for at least two more years and this will keep investors happily in the Doghouse.

Even investors of stocks that are not a part of the DJIA have the potential of benefiting from the Dogs of the Dow concept. The WSJ noted that “Gary Goldman Financial Services will launch a strategy in January (2011) for separately managed accounts that applies the Dogs concept to members of the Standard & Poors 100 and the S&P 500 with some additional criteria.” These criteria will include more fundamental analysis with regard to the sustainability of the dividend.

These Dogs Will Hunt

If using the Dogs of the Dow strategy seems like an excellent way to get the advantages of exposure to the stock market while avoiding some of the volatility, be advised that even Dogs take a nap sometimes and any strategy, no matter how attractive, can come back to bite the investor. Many factors can move the market and careful consideration must be given to any investment.

However, if 2011 seems like a good year to let your stock portfolio go to the Dogs, the ten stocks that fit the highest-yield criteria are as follows: AT&T (5.85% yield), Verizon (5.46%), Pfizer (4.57%), Merck (4.22%), Kraft Foods (3.68%), Johnson & Johnson (3.49%), Intel (3.42%), Dupont (3.29%), McDonald’s (3.18%) and Chevron (3.16%) (Source: Wall Street Journal 1/3/11).

Financial planners who advocate this Dogs of Dow strategy recommend that investors put an equal amount of money in each of these 10 stocks and then sit back and watch what happens. After a year, take a look at the DJIA and sell those stocks that no longer meet the 10 highest yielding stocks criteria and buy those that do.

Before investing the kids’ college fund in any stocks, it’s probably a good idea to speak with a reputable financial planner or conduct additional research. History has shown that using the Dogs of the Dow strategy is a reasonably safe bet. After all, every dog has his day.