Every dog has its day: the strategy of buying a package of out-of-favor Dow stocks could shine even brighter in a market downturn

Kiplinger's Personal Finance Magazine, July, 1998 by Manuel Schiffres

The strategy of buying a package of out-of-favor Dow stocks could shine even brighter in a market downturn.

Booker T. Washington Jr. concedes that he's "about as neophytish as you can get with this investment business." But the retired vocational high school masonry teacher and part-time bricklayer in suburban Chicago knows the importance of a sound foundation. Perhaps that's why he's drawn to a simple investment scheme with a reputation for delivering solid returns.

Washington, 58, has discovered the Dogs of the Dow--the increasingly popular strategy of buying the ten highest-yielding stocks in the venerable Dow Jones industrial average. This collection of some of the biggest and best-known companies gets the derisive canine classification because the high yields are usually the result of beaten-down, or at least lagging, stock prices. But you can't scoff at the return: Over the past 25 years, the strategy has produced robust annualized gains of 18%.

Washington is leaning toward investing one-third of his financial assets in a Dogs of the Dow unit investment trust (UIT)--a prepackaged portfolio that is sold by brokerage companies. His money will join the $50 million to $100 million a week that has been flooding into UITs sponsored by a consortium of four major firms: Merrill Lynch, Morgan Stanley Dean Witter, PaineWebber and Salomon Smith Barney. Their UITs already devote more than $10 billion to the bowwow strategy.

A feverish fad or flight to safety?

Ironically, investor interest is surging just as skeptics are beginning to question whether these dogs have, well, gone to the dogs.

In three of the past four years, an investor would have done better by investing in all 30 Dow stocks than by focusing on the ten dividend leaders. Only twice in the past four years have the dogs outpaced Standard & Poor's 500-stock index. H. Vernon Winters, chief investment officer at Mellon Private Asset Management, suggests that so many people are throwing money at the dogs--and thus forcing prices up--that it is increasingly difficult for new money to excel.

But defenders of the dogma say its critics miss a crucial point. Because it focuses on yield, this strategy is a conservative one that will rarely prevail in blistering markets. "When you're in a market that goes up relentlessly every day, it's hard for a stock like GM to keep up," says James O'Shaughnessy, head of a company that runs a mutual fund that invests partly in the dogs. He and other fans argue that the strategy will really shine in the next bear market.

Indeed, the scheme's finest years--relative to the entire Dow--came during the gruesome 1973-74 bear market. Over that two-year span, the dogs lost a tad more than 1%, including dividends, while the 30 industrials combined plunged a sickening 33%.

This technique--also known as the Dow dividend strategy--owes its success to the fact that it identifies out-of-favor companies with staying power. As noted earlier, a stock typically becomes one of the Dow's top yielders because its price declines or doesn't increase as fast as other Dow stocks. If a company maintains its dividend while the share price falls, the stock's yield automatically rises (yield is defined as the annual dividend rate divided by share price). If the price falls too much, resulting in an ultrahigh yield, it's often a sign that a company is in so much trouble that it may have to trim or eliminate the payout. But Dow stocks are so financially powerful that they usually withstand downturns, maintain their dividends and bounce back smartly. That's why it can make sense to use the Dow dogs to occupy all or part of an investment portfolio devoted to large undervalued stocks.

How to get started

The strategy involves three steps:

1. Identify the ten highest-yielding Dow stocks. The current players are shown in the box on the facing page. At other times, check newspaper stock tables (the Wall Street journal lists all Dow stocks in each issue) or, if you're a computer user with access to Quicken's Web site (www.quicken.com), set up a "portfolio" of Dow stocks and track yields daily.

2. Invest equal dollar amounts in the ten highest-yielding companies. Although this part of the strategy gets the most attention at the beginning of each year, you can start at any time.

3. Update your portfolio each year by selling stocks that no longer make the top-ten list and replacing them with the dog debutantes. Hold on to the rest. Tuning up your portfolio gets tricky because, to be a purist, you need to allocate 10% of the total value to each stock. That will probably require that you buy or sell a few shares of holdovers.

Until last year, annual updates blended nicely with tax law. Profits on stocks kicked out of the doghouse after one year and a day qualified for favorable tax treatment. But now you have to hold shares for more than 18 months to qualify for the lowest tax rate on capital gains. Dog-strategy watchers say that the one-year holding period shouldn't be considered sacrosanct and that, in fact, history indicates no appreciable difference in performance between 12-month and 18-month holding periods. Therefore, investors in taxable accounts should probably rejigger portfolios every 18 months plus a day to capture the tax break.