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

Entrepreneur, Oct, 1997 by Lorayne Fiorillo

3. Eliminate companies with S&P quality rankings less than "A" (75 left).

4. Rank stocks by market capitalization, eliminating the bottom 25 percent (55 left).

5. Rank remaining stocks by dividend yield and invest equal amounts in the 15 with the highest yields.

As with the DDS, the portfolio is held for a year and then rebalanced.

Hypothetical results from back-testing reveal interesting results. From 1972 through the end of 1996, this strategy would have beaten the S&P Industrial Index in 16 of the past 25 years and the DJIA in 14 of the past 25 years while posting only three down years. The average annual return for the period from 1972 to the end of March 1997 is 17.49 percent vs. 12.76 percent for the DJIA and 12.34 percent for the S&P 500. Since it holds none of the same stocks as the DDS, this strategy nicely complements the DDS. Keep in mind, investors cannot invest directly in a specific index.

Feel like going international? The same type of strategy used on the components of the DJIA and S&P 500 indices can be used on foreign indices as well. But remember that foreign investments are subject to additional risks, such as currency fluctuation and social, political and economic uncertainty.

Portfolios taken from the Financial Times Stock Exchange (London), Hang Seng (Hong Kong) and Nikkei (Tokyo) indices have shown interesting results when back-tested for various periods. The Financial Times Top 10 have beaten the underlying index of 30 stocks 15 out of the last 20 years and three out the last five years. Back-tested performance to 1977 shows an annualized total return for the strategy of 24.08 percent vs. 16.51 percent for the Financial Times index through December 31, 1996.

The Hang Seng Top 10 has beaten its underlying index in 10 of the last 18 years; and back-tested performance to 1978 shows an annualized total return for the strategy of 22.71 percent vs. 21.65 percent for the Hang Seng index through December 31, 1996. Back-testing performance for the Nikkei from 1977 through December 31, 1996, shows a return of 20.13 percent for the strategy vs. 13.39 percent for the index.

If you're thinking of adopting a pet or two, make sure you've got room for the "dogs" you select before you invest in a leash and collar. Investors can buy shares in individual issues and rebalance positions annually themselves. Though these dogs don't need a big yard or lots of exercise, often the best place to put them is in a tax-deferred account such as an IRA or a retirement plan. That way, when the portfolios change, capital gains and dividends won't be taxable. And that may be one way to win best of show.

Lorayne Fiorillo is a financial advisor and first vice president at Prudential Securities Inc. For a list of the current "dogs of the Dow, "send a self-addressed, stamped envelope to her in care of Entrepreneur, 2392 Morse Ave., Irvine, CA 92614.