Dogs Of The Dow With A Twist

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Includes: AA, CAT, DD, GE, HPQ, IBM, INTC, JNJ, KHC, KO, MCD, MRK, MSFT, PFE, PG, T, UNH, VZ
by: New Low Observer

The new year is right around the corner and we're not letting the fiscal cliff stop us from searching for investment ideas. We've decided to turn to an old strategy, the Dogs of the Dow which was introduced by Michael O'Higgins, for some potential opportunities. The Dogs of the Dow strategy suggests that you buy the top ten highest yielding stocks of the Dow Jones Industrial Average at the beginning of each year.

The top ten companies were AT&T (NYSE:T), Verizon (NYSE:VZ), Kraft Foods (KRFT), Merck (NYSE:MRK), Pfizer (NYSE:PFE), General Electric (NYSE:GE), Johnson & Johnson (NYSE:JNJ) and Procter & Gamble (NYSE:PG). Below is the performance of the "Dogs" for 2012.

Ticker Company 2012 Price 12/27/12 2012 Yield 12/27/12 Yield YTD % Chg
T AT&T, Inc. 30.5 33.7 5.80% 5.30% 10.50%
VZ Verizon 40.3 43.5 5.00% 4.70% 7.90%
KRFT Kraft Foods 38 44.4 4.80% 4.40% 17.00%
MRK Merck 37.9 41.2 4.50% 4.20% 8.80%
PFE Pfizer Inc. 21.9 25.1 4.10% 3.80% 15.00%
GE General Electric 18.2 20.7 3.80% 3.70% 13.50%
DD Dupont 46.6 45.1 3.60% 3.80% -3.20%
JNJ Johnson & Johnson 65.6 70.1 3.50% 3.50% 6.90%
INTC Intel Corporation 24.6 20.5 3.50% 4.40% -16.70%
PG Procter & Gamble 66.3 68 3.20% 3.30% 2.50%
- Dogs of the Dow - - 4.16% 4.11% 6.21%
Click to enlarge

The top 10 highest yielding companies of the Dow averaged a return of +6.2% compared to the S&P 500 gain of +12.7% and our NLO portfolio gain of +7.4%. The biggest laggard of the group was Intel (NASDAQ:INTC) which is one of our top holdings, down -9% since our purchase.

It should be noticed that Kraft Foods is no longer a component of the Dow Jones Industrial Average but has been the best performer of all ten companies. As pointed out in our 2012 Nasdaq 100 Re-Rank Review (found here), stocks dropped from an index normally outperform, overall. In the case of KRFT, it was dropped late in the year after spinning off a unit.

As the new trading year begins, these companies would be the Dogs of the Dow for 2013.

Ticker Company Current Price Current Yield
T AT&T, Inc. 33.32 5.40%
VZ Verizon 42.90 4.80%
INTC Intel Corporation 20.23 4.40%
MRK Merck & Co. Inc. 40.64 4.20%
HPQ Hewlett-Packard 13.68 3.90%
DD Dupont 44.71 3.80%
PFE Pfizer Inc. 24.89 3.90%
GE General Electric Company 20.44 3.70%
JNJ Johnson & Johnson 69.48 3.50%
MCD McDonald's Corp. 87.58 3.50%
- Dogs of the Dow Average yield 4.11%
Click to enlarge

There are eight companies that are being carried over from the previous year. Hewlett-Packard (NYSE:HPQ) and McDonald's (NYSE:MCD) are the new additions. Hewlett-Packard made the list after the stock slumped -45%. Interestingly, HPQ has the lowest payout ratio using next year's estimated earnings of $3.48.

The primary issue we have with the "Dogs of the Dow" strategy is that it assumes all 30 companies have similar retained earnings and payout ratios. However, we believe that the dividend yield is a relative valuation and not an absolute figure. As an example, utilities and telecom companies will typically have higher yields than those of other industries such as technology.

As an alternative, we have come up with a different approach to the "Dogs" strategy to determine if there is any merit to our "relative value" assessment. Instead of looking at the 10 highest yielding stocks of the Dow Jones Industrial Average, we will look at the top 10 stocks closest to their respective 52-week low. We'll call this the "Dogs of NLO."

Among our top ten are Microsoft (NASDAQ:MSFT), McDonald's, Intel, Dupont (NYSE:DD), Alcoa (NYSE:AA), IBM (NYSE:IBM), UnitedHealth (NYSE:UNH), Coca-Cola (NYSE:KO), Merck and Caterpillar (NYSE:CAT).

Ticker Company Current Price Current Yield
MSFT Microsoft Corporation 26.55 3.50%
MCD McDonald's Corp. 87.58 3.50%
INTC Intel Corporation 20.23 4.40%
DD Dupont 44.71 3.80%
AA Alcoa Inc. 8.50 1.40%
IBM IBM 189.83 1.80%
UNH UnitedHealth 53.86 1.60%
KO Coca-Cola 35.97 2.80%
MRK Merck & Co. Inc. 40.64 4.20%
CAT Caterpillar Inc. 86.81 2.40%
- Dogs of NLO Average Yield 2.94%
Click to enlarge

It should be noticed that the dividend yields are considerably less than that of the Dogs of the Dow strategy. Some could argue that having a low yield will likely result in a lower return, however, as we've demonstrated in an article dated April 24, 2010 titled "Low Yielding Stocks Offer Exceptional Gains" (found here), the one year gains for low yielding stocks can be outsized. In another article dated November 10, 2010, titled "Comparing Two Dividend Strategies" (found here), a comparison of low dividend yielding stocks to high dividend yielding stocks, the low yielding stocks have outperformed by an ever increasingly wide margin as time has passed (2-year updates found in an article titled "Comparing 2 Dividend Strategies: Redux").

Again, this article is to provide a look back at the Dogs of the Dow performance in 2012 and possible picks for 2013. Based on our work with dividend increasing stocks, we feel that the "Dogs of NLO" has a higher chance of outperforming the strategy initiated by Michael O'Higgins in 1991. Only time will tell, so we'll be sure to check back for a review one year from now.

Disclosure: I am long INTC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.