Good dog! Investing in stocks considered the "dogs" of an index won't have you chasing your tail

Entrepreneur, Oct, 1997 by Lorayne Fiorillo

We're not talking about adding just any old mongrel to your portfolio. The idea is to buy the 10 DJIA stocks that currently sport the highest yields - the "dogs of the Dow." The trick is to buy equal amounts of these 10 stocks and hold them for a year. After 12 months, you'll reassess your holdings, replacing lower-yielding stocks with those that are the current year's dogs.

These stocks are referred to as "dogs" because although the underlying companies are well-established and have high dividend yields, they have fallen out of favor and their prices have been driven down. It is hoped that although they are beaten down at the moment, they will enjoy a turnaround and do better in the future. Since we wrote about it two years ago, investors have poured hundreds of thousands of dollars into the Dow Dividend Strategy (DDS), as it is known, effectively forcing themselves to buy low and sell high. Of course, there is no assurance, nor does this imply, that the stocks are being bought at the bottom and that they'll move up from there.

Through the DDS, investing in the dogs of the Dow allows investors to focus on household-name companies with long histories. By emphasizing the 10 highest-yielding stocks rather than the 10 DJIA stocks with the highest dividends, the DDS aims for enhanced total return from both capital gains and dividends. How does it work? Consider that yield is an inverse indication of a stock's popularity. As a stock's price rises, its yield falls. Look at it this way: Yield=annual dividend/stock price.

If ABC Corp. pays a $10-per-share annual dividend and the share price is $50, ABC's yield is $10 divided by $50, or 20 percent. If the share price of ABC rises to $100 while the dividend remains the same ($10), the new yield is 10 percent. At first glance, the drop in yield seems negative, but what has actually happened is a bonanza: capital gains and income, a pedigree worth having. Compared to other investment strategies, investing in the Dow's dogs is easy.

A variation on the theme, the Low 5 Dow Dividend Strategy limits the portfolio to the five highest-yielding stocks. Investors choose the five lowest-priced stocks of the DDS on the day their portfolio is established. Again, the portfolio is held for a year and all dividends are reinvested. Whichever strategy is selected, ideally investors continue it, adjusting positions annually for the life of their "pet," for at least one complete market cycle of three to five years. Both strategies are considered to be long-term strategies, which should be made with the understanding of the risks associated with common stocks.

* CHAMPION BLOODLINES

Both the Top 10 and the Low 5 DDSs have historically rewarded investors. And while past performance is no guarantee of future returns, in the period beginning January 1977 through the last trading day of 1996, assuming total return proceeds were reinvested at the beginning of each calendar year, the 20-year record puts the DDS ahead of the DJIA with an average compounded annual total return of 17.62 percent vs. 14.25 percent for the full 30 DJIA stocks.

Surprisingly, the Low 5 provides an even higher average compounded annual return for the same 20-year period - 20.18 percent. Put it this way: Hypothetical investors who put $10,000 in the Low 5 DDS at the beginning of 1977 and followed the strategy annually could have seen their investment grow to more than $395,000 in 20 years, compared to the more than $256,000 for the DDS Top 10 portfolio and the nearly $144,000 for the full DJIA portfolio. (Results exclude the effect of state and federal taxes, commissions, and sales charges.)

There are two forces at work behind the returns of the DDS strategies. The first is the effect of yield. Dividends paid by the companies in the DJIA have increased in 60 of the past 68 years, and this accounts for about 40 percent of the overall return. Second, compounding these dividends accounts for 10 percent of the improved total return. The success of the DDS offers another reason why time in the market is more important than timing the market.

* A DIFFERENT BREED

The strategy of selecting the stocks with the highest yields from a well-known index isn't limited to the DJIA. By back-testing several variations of the high-dividend strategy, investors can uncover a plethora of investment options. Whether you're looking overseas for diversification or prefer to keep your investments stateside, there is more than one way to skin a cat.

First, for landlubbers, consider a strategy using a subset of the widely recognized S&P 500 Composite Stock Price Index. The S&P 500 features utility, financial, transportation and industrial stocks. The S&P Industrial Index, a subset of the S&P 500, includes only highly capitalized industrial stocks. While many permutations can be made from these lists of companies, here's one strategy investors have found to be productive:

1. Begin with the S&P Industrial Index (approximately 380 stocks).

2. Eliminate DJIA stocks (approximately 350 stocks left).