"Dogs of the DOW" refers to an investment strategy which proposes that investors should annually invest in the ten Dow Jones Industrial Average (DIA) stocks whose dividend is highest as a fraction of their price. The rationale behind this investment strategy is that companies change their dividends based on the long-term sustainable earnings prospects of the company, not because of stock trading value. Therefore, the dividend yield becomes a good measure of relative value, with high yield stocks being in a better position to rebound and exhibit higher share price growth.
At the end of 2013 the companies making the Dogs of the DOW list in order of highest to lowest dividend yield included: AT&T (T), Verizon (VZ), Merck (MRK), Intel (INTC), Pfizer (PFE), McDonald's (MCD), Chevron (CVX), General Electric (GE), Cisco (CSCO) and Microsoft (MSFT). The companies are listed with their current annual dividend payout level and yield as of 12/31/2013 are shown in the following table.
The investment strategy, although historically a means of obtaining portfolio outperformance, is not always successful. Notable years in which the strategy underperformed were during the late 1990s dot.com boom. I have written recent articles which reference the similarities in the current stock market when compared to that period of time. For that reason alone, I look with some skepticism on using this strategy in its purest form in the coming year. However, as a value investor, I have found that searching for value by shifting through the higher yield payers can lead to discovery of undervalued gems. The question becomes, on what basis do you determine when a stock is truly undervalued relative to the rest of the field?
When I look at stocks currently, there are two fundamental criteria that I am looking for most - revenue and earnings growth momentum. The current economy has been stuck on low to no growth for some time, and a majority of companies in the DOW since the depth of the financial crisis in 2008 have squeezed operating margins to achieve earnings growth, but in many cases revenue growth has been lacking. In my simple view, finding low P/E companies with good earnings and revenue growth momentum at the present stage of the business cycle should create investment rewards.
Based on this view, in the remainder of this article I reviewed the 10 DOW Dogs of 2013 against 3 criteria to determine if there is a more refined subset of potentially undervalued companies in the group:
- Revenue Growth since 2008 and the Trailing 12 Months (TTM) thru 3Q'13
- Earnings Growth since 2008 and the TTMs thru 3Q'13
- Price / Earnings Ratio based on 12/31/20013 stock price and TTM earnings thru 3Q'13
At the end of the article I judge the dogs, and award win, place and show status to the companies which rank highest based on this analysis. In addition, the ugliest DOW dogs are reviewed.
Wide Divergence in Revenue Growth
One observation stands out in reviewing the recent history of the DOW in terms of revenue growth - not all companies are created equal. Some of the DOW Dogs have been able to generate growth, while others have been continually hampered. The biggest revenue growth laggards in the DOW have been in the oil sector Chevron and Exxon (XOM), as well as companies with exposure to the financial sector such as General Electric, J. P. Morgan (JPM), Goldman Sachs (GS) and Travelers (TRV). The common theme is that the financial sector revenue stream has still not recovered to levels which were exhibited pre the 2008 crisis, most likely due to Federal Reserve policy of repressed interest rates; meanwhile, the energy sector although price levels rebounded to near $100 a barrel for oil, is not producing the same level of revenue as 2008. Low natural gas prices and relatively low oil prices, (need I remind investors that oil spiked to $140 a barrel in 2008), are significant factors in the lack of revenue growth momentum in the sector.
The higher performing companies in terms of revenue growth in the DOW Dogs can be seen in the green shaded areas in the above table. The two companies that stand out in this review are Microsoft and Cisco, both in the large cap technology sector. Microsoft had a particularly strong showing over the past year, ranking 3rd in DOW companies for revenue growth based on TTM growth through the 3rd quarter of 2013. Intel also has exhibited solid revenue growth over the past five years; however, growth slowed down in momentum over the past year. Whether the slowdown for the chip maker is permanent or a temporary hiccup may be important in the final judgment on whether Intel is a value play in the coming year.
Verizon has also shown consistent above average revenue growth over the 5 years post crisis and on a TTM basis. The performance is in direct contrast to the consistently poor revenue growth at AT&T. In an industry where Smartphone devices have been the major buzz, and video streaming and internet commerce expansion has been a bright spot, Verizon is clearly doing relatively better than their primary North American rival.
DOW Dog Earnings Growth Shows Sector Split
Just as the revenue growth favored certain DOW Dog tech companies over the past 1 and 5 year time periods, so too has the growth in earnings. The rankings shaded in green in the table below illustrate this point.
The past 12 month earnings growth at Verizon is distorted as it comes a year after the company took substantial "non-operating" write-offs. Cisco and Microsoft showed improvement that surpassed the performance of many of their peers in the index. Intel, which had exhibited strong growth from 2009 through 2012, showed a steep decline in earnings over the last 12 months. The remaining Dogs of the DOW, with the exception of Pfizer, have shown very poor earnings growth, well below the average 4.6% growth in the DOW composite on a Trailing 12 month basis, and in most cases well below the 5 year growth average.
Relative Value Based on P/E Ratio
The last area I always review when doing a relative comparison of companies is the current P/E ratio. In the comparison of the DOW Dogs, again it was the technology sector that stands out as the relatively undervalued group in the DOW.
The one exception is Chevron, which has the lowest P/E ratio in the DOW when measured on a TTM basis as of the 3Q 2013.
Best Dogs in the Show based on Review Criteria
In order to rank the 2013 DOW Dogs on a relative basis, I used a composite scoring system which aggregates the DOW rank for each company in each of the 5 categories explained in the previous sections. For instance, Microsoft has a composite score of 46, which is calculated as follows:
5 Year Revenue Growth Rank: 8
TTM Revenue Growth Rank: 3
5 Year Earnings Growth Rank: 20
TTM Earnings Growth Rank: 6
P/E Ratio Rank: 9
If you add Microsoft's dividend rank of 10 out of the 10 DOW Dogs, the Score + Dividend Rank of 56 is obtained. Each of the companies has been evaluated using the same methodology.
The results of the relative comparison analysis are contained in the table above. Using the analysis I have declared Microsoft the winner of the Dog show, followed very closely by Verizon and Cisco. Honorable mention goes to Intel, who if not for the TTM earnings lapse would have been a contender.
In a recent article, I was asked in the comment section to explain why I favored technology going into 2014. This analysis is a factor in my overall consideration - the stock market has risen and left the fundamental companies that are actually growing both revenue and earnings behind. If the Federal Reserve training wheels are indeed going to be removed, then fundamentals are going to need to return to the forefront in stock selection. Microsoft and Cisco both are well positioned to benefit if economic expansion continues, particularly if business capital investment improves.
Verizon is well positioned with it's dominate position in the wireless market to continue to garner revenue growth in the expanding internet marketplace. Verizon is on the forefront of the wireless technology introduction curve, planning to launch its voice over LTE (VoLTE) service in the first half of 2014. The service will allow voice calls to be made over Verizon's 4G LTE network. Once VoLTE becomes available, Verizon can offer LTE-only devices that don't require as many cellular radios in the network, improving company operating margin in the future - a critical component to delivering long-term shareholder returns in the telecom industry. One of the hesitations by many analysts in the review of Verizon is the potential constraints the $130B price paid to purchase the remaining stake in Vodafone (VOD). To complete the purchase, Verizon increased its debt load $47B in the 3rd quarter of 2013, increasing its debt to equity ratio from 1.57 to 2.83. Leverage is a double edge sword, but in this case Verizon may reap the reward of excellent timing as they have been one of the very few DOW companies to actually leverage up as long-term interest rates bottomed, to expand their market position in an industry they are a clear leader.
Contrarian Plays - Ugly Dogs
The ugliest Dogs in the DOW in my opinion, and analysis, are General Electric, AT&T, Merck and Chevron. Being labeled the ugliest is not necessarily an indication there is no hope at the current stock valuation; only that clearly something needs to change in order for these "Dogs" to make a run. With P/E ratios of 20 and above in the case of GE, AT&T and MRK, expectations seem a bit overdone given their recent track record. The possibility of an upturn in the industrial sector may give hope for GE shareholders, but a lot of the future appears already priced in.
This assessment leaves the Big Oil sector as my best contrarian pick in the Dogs of the DOW list. Despite a contracting top-line and static earnings growth, I see relative value in Chevron because investors are not over paying for the future - in my opinion. In fact, they are probably getting a decent hedge at a bargain price. Chevron maintains the lowest P/E ratio in the DOW. If the economy is going to grow domestically and worldwide, then energy demand will have to rise. And the economy should expand until the integrated oil sector yet again posts record profits. We have some time to go in the business cycle before this happens, but I expect that it will as we approach 2016.
Currently the energy market is pricing in a downturn in oil prices in the U.S. market below $80 a barrel over the next 5 years. On a relative basis, this future scenario is priced into the shares of many companies in the sector except for some of the high flying E&P companies such as Pioneer Natural Resources (PXD). But, what if the future does not turn out this way … My favorite in the big oil sector is not a DOW component; it is British Petroleum (BP), because it has a dividend yield of $4.70% and trades at a P/E ratio of 6.56 - a pure dog that has plenty of upside.
Daniel Moore is the author of the book Theory of Financial Relativity: Investment Portfolio Guidance in a Federal Reserve Driven Bubble Prone Deflationary Era. All opinions and analyses shared in this article are expressly his own, and intended for information purposes only and not advice to buy or sell.