Dogs of the Dow

The “Dogs of the Dow” is a well-known investment strategy that revolves around selecting the highest dividend-yielding stocks from the list of the Dow Jones Industrial Average (DJIA). This approach aims to take advantage of the cyclical nature of high-yield stocks and their potential for capital appreciation as they revert to mean valuations over time. The strategy, while simple in its conception, has garnered a significant following and has spurred a variety of analytical approaches, adaptations, and discussions within the investment community.

History and Background

The Dogs of the Dow strategy was popularized by Michael B. O’Higgins in his 1991 book, “Beating the Dow.” The premise is grounded in the belief that large, well-established companies in the Dow are unlikely to experience long-term declines and that high dividend yields often indicate undervalued or out-of-favor stocks poised for recovery.

The theory suggests that by annually picking the top ten high-yielding Dow stocks, investors can potentially outperform the overall market. The rationale is twofold: the high dividend yield provides a steady stream of income, and the relatively low stock price (that causes the yield to be high) might recover, thus providing capital gain.

The Mechanics of the Strategy

1. Identifying the Dogs

At the end of the year, an investor screens the 30 stocks in the Dow Jones Industrial Average to find the ten stocks with the highest dividend yields. The dividend yield is calculated by dividing the annual dividend per share by the stock’s price per share.

2. Equal Allocation

The investor then equally allocates their investment across these ten stocks. This equal allocation ensures that the investor isn’t disproportionately exposed to any single stock or sector, helping to diversify risk.

3. Annual Rebalancing

At the end of each subsequent year, the process is repeated. The portfolio is rebalanced to once again hold the new list of the top ten highest dividend-yielding Dow stocks.

Financial Rationale

Dividends as Indicators

High dividend yields can often indicate stocks that are temporarily undervalued. Investors are paid to wait through dividends until the market recognizes the intrinsic value of the company. Historically, dividends have also been a significant component of total return in the stock market, providing steady income regardless of stock price volatility.

Mean Reversion

One of the core pillars of the Dogs of the Dow strategy is the concept of mean reversion. This theory posits that high-yield stocks, more often than not, are priced lower due to temporary issues that are inherently fixable or overestimated by the market. Over time, these prices correct, and the yields come back to an average level as the stock price appreciates.

Adaptations and Variations

The simplicity and historical effectiveness of the Dogs of the Dow strategy have led to several adaptations:

Small Dogs of the Dow

This variation involves picking only the five lowest-priced highest-yielding stocks from the original ten. The idea is that lower price stocks have higher potential for significant gains, albeit with higher risk.

International Dogs

Applying the same principle to other global markets, investors can seek the highest dividend-yielding stocks in indices outside the U.S., such as the FTSE 100 or Nikkei 225.

Dividend Aristocrats

Some investors choose to focus on high-yield stocks that also have a history of increasing dividends, applying the Dogs strategy within a subset of companies known for reliable dividend growth.

Performance and Criticisms

Historical Performance

Over various time periods, the Dogs of the Dow strategy has generally performed well against the Dow Jones Industrial Average. Its focus on dividends has provided a cushion during bear markets, and the principle of buying undervalued stocks has led to significant capital appreciation in bull markets.

Criticisms

  1. Sector Concentration: At times, high-yield stocks can be concentrated in specific sectors facing broad challenges, leading to overexposure to particular industries.
  2. Value Trap: Stocks with high yields due to plunging prices might be in long-term decline rather than temporary setbacks, leading to potential underperformance.
  3. Simplistic Approach: Some critics argue the strategy is overly simplistic and doesn’t account for broader market conditions, company fundamentals, or macroeconomic factors.

Resources and Tools

Official Website

For those interested in regularly updated data and community discussions about the Dogs of the Dow strategy, the official website dogsofthedow.com serves as a central resource.

Stock Screeners and Financial Services

Many financial platforms now provide tools and screeners tailored to the Dogs of the Dow strategy, allowing investors to easily identify high-yield Dow stocks:

Conclusion

The Dogs of the Dow remains a popular and accessible strategy for individual investors seeking a combination of income and potential capital gains. While not without its drawbacks, its historical performance and simplicity make it a prominent fixture in the landscape of dividend investing strategies. By adhering to a disciplined, rules-based approach, investors can leverage the cyclical nature of high-yield stocks within one of the most established indexes in the financial world.