Dogs of the Dow teach investors new tricks
By John Prestbo
Mar 3, 2010

NEW YORK (MarketWatch) -- "Dogs of the Dow" investors may be barking up the wrong tree.

This investing strategy, devised about two decades ago, is to buy the highest-yielding stocks in the Dow Jones Industrial Average (INDU ) each year, sell them a year and a day later (to qualify for more favorable long-term capital gains tax treatment) and start over.

The goal, in the words of the strategy's inventor, Michael B. O'Higgins, is to "beat the Dow" in total return performance.

Beat-the-market strategies work some of the time, or else they would not be promoted. O'Higgins claims in the 2000 version of his book, "Beating the Dow," that in the 26 years from 1973 through 1998 the strategy returned more than the Dow in all but eight periods. In several years the outperformance was substantial, he points out.

So popular did this strategy become that Dow Jones built indexes to track the original 10-stock strategy and a variant, the five lowest-priced stocks among the 10 highest-yielding. The results have been disappointing, however, especially in recent years.

In the 22 years from 1988 through 2009, the Dow 10 index bested the full DJ Industrial Average only nine times. The Dow Five index did better, outperforming the Dow in 12 years. But neither left investors better off than the Dow itself.

Over the entire span, the Dow itself returned 837.4% in combined price gains and dividend payments, or 10.7% annualized. The Dow 10, by comparison, returned 658% cumulatively, or 9.6% annualized. The Dow Five's scorecard was a somewhat better 683%, or 9.8% annualized.

Through February, the Dogs are up 0.63% this year compared to a decline of 0.47% for the Dow. If that trend continues, it will be the first time since 2006 that the Dogs came out on top.

Why has the Dogs' batting average dropped? The main reason is that both the market and the Dow have changed in the past 20 years. O'Higgins himself observes that more companies are buying back shares to boost stock performance in a capital gains-friendly way. The result is reduced importance of dividends as a means of returning profits to shareholders, thereby weakening their market "signal."

As for the Dow, it has five technology stocks these days, four more than when O'Higgins started his kennel. The latest addition was Cisco Systems Inc. (CSCO, Trade ) last summer. Technology stocks never have been in the Dow 10 or Dow Five -- even after the dot-com bubble burst -- mainly because they pay small dividends, if any. However, technology has powered more than a few of the Dow's gains in the past decade, including 2009.

Nonetheless, there still is a lot to like about the Dogs strategy. For one thing, the Dow's universe of 30 well-known blue-chips limits risk right off the bat. Picking the handful that are temporarily out of favor, as evidenced by the higher yields, can be done with more confidence that dividends will not be cut, or that the companies' fortunes will slip from bad to worse. (Confidence, that is, not assurance. See General Motors Corp. and Citigroup (C, Trade )

There is merit in waiting for the subpar performance of these high-yield and/or low-priced stocks to revert to average -- and, who knows, maybe even accelerate into above-average range. Again, there are no guarantees, but Dow stocks are chosen in part for their stamina and resilience.

The problem with the Dogs of the Dow is not the strategy itself, but positioning it as a way to beat the market. The track record is becoming less reliable in that regard anyway, so maybe it is time to rethink the objective.

How about this: Use the Dogs to enrich the yield of your portfolio. Instead of trying to lock in capital gains every 367 days or so, buy these knocked-down blue chips to capture the dividend yield. And some of those yields are juicy, indeed.

Here are the top 10 highest-yielding stocks for 2010 (picked Dec. 31, 2009), with closing prices and yields as of Feb. 26:

The average yield of these 10 is 4.34%. That is more than twice the current yield on the Standard & Poor's 500-stock index (SPY, Trade ) and a tad higher than the Dow's yield at the end of March 2009.

Or you might focus on just the top five: Their average yield is an impressive 5.28%. The lowest-priced five yield slightly less, 4.91%.

This approach turns the Dogs strategy into an equity-income fund, except with fewer stocks and richer yields. In contrast, Vanguard Equity Income Fund's Investor-class shares (VEIPX, Trade) yield 2.76%; Fidelity Equity Income II Fund (FEQTX, Trade) yields 1.38%. Both have far more diversification than the Dogs approach offers, while the Dogs are concentrated in blue-chip names.

In another deviation, I would not sell any of these shares based on the calendar, as the Dogs strategy dictates. Personally, I would wait until a Dow stock with a fatter yield came along, or until a capital gain was too attractive to pass up.

If I had started this kind of portfolio in 2000, I would now have 17 stocks. That is assuming I would avoid duplicates (J.P. Morgan Chase & Co. (JPM, Trade ), for instance, was a Dog in each of the past 10 years) and would drop those that subsequently lost their Dow membership. Their collective yield would be around 4%.

I would also sell if a Dow Dog cut its dividend, unless the new yield remained in the current top 10. Last year, when General Electric Co. (GE) chopped its payout to 10 cents a quarter from 31 cents, GE's stock price had fallen so low that even the shrunken dividend produced a yield of 4.7%. It is easy to check yield rankings by downloading the current Watch List for the Dow 10 index on the Dow Jones Indexes website ( See the Dow 10 ).

This approach is not as mechanical as the Dogs of the Dow. It is also not as costly, in terms of trading commissions and capital gains taxes.

Importantly, I would not make this Dogs portfolio my sole exposure to stocks. But as a supplemental investment, focused on income at a time when interest rates are low, the Dogs offer strong cash generation and the possibility of capital appreciation. That combination is appealing. Let somebody else knock themselves out trying to beat the market. Strong dividends are the stock-market version of "money in the bank."