Dogs of the Dow, Revisited

by: Tom Au, CFA

The Dogs of the Dow (the ten highest yielders) are beating the whole index so far in 2010. This doesn't happen every year. But there are reasons, based on the configuration of the Dow at the end of 2009, that it is happening this year.

To a greater extent than has been the case in the twentieth century, most of the Dogs of the first decade of the twenty-first century have been "perennials" (repeaters). These include the telecom company Verizon (NYSE:VZ), since it joined the Dow in 2004, and AT&T (NYSE:T) (the former SBC) which has been on the list for all of the new century; it was last off it in the late 1990s. Chemical maker DuPont (NYSE:DD) has been a "Dog" every year in the current century, as has Kraft (KFT), and its predecessors Altria (NYSE:MO) and Philip Morris (NYSE:PM). Pharmaceuticals Merck (NYSE:MRK) and Pfizer (NYSE:PFE) "belong" on the list; the one year that each wasn't was a sign of overvaluation.

Banks such as Citigroup (NYSE:C) and JP Morgan Chase (NYSE:JPM) were on the list for most of the decade, until the dividend cuts of 2008-2009, as was the case with General Motors and General Electric (NYSE:GE), industrial companies with large "captive" finance operations.

In 2000 and 2006, the highest single yielders, Philip Morris and General Motors were particularly strong performers because they started the year with yields of 8.35% and 10.30% respectively. Such high yields signal that either the dividend is going to be cut--or the stock is going to outperform. (Phillip Morris never cut its dividend until it split into three parts years later, and General Motors' dividend elimination was two years in the future, in 2008.) In those years, as well as 2003, the outperformance of the Dogs was led by the outperformance of the three highest yielders. The Dogs also outperformed in 2002 because of the high-yielders' defensive qualities in a strongly down year.

Even so, stocks that are "perennially" cheap tend not to beat the market, which is why the Dogs failed to do so in the other years of the past decade. Instead, the market beaters are often stocks that are temporarily cheap, "fallen angels" that have unusually high yields for THEMSELVES, either because their prices are unusually low, or because they have raised their dividends quickly.

Because of the recent turnover with the banks and large industrials, last year's Dogs of the Dow featured a few rotators, including McDonald's (NYSE:MCD) and Boeing (NYSE:BA). These are two of this year's outperformers. A third is DuPont, a "perennial" Dogs stock that ended 2009 with the third highest yield on the list, making it unusually cheap even relative to ITSELF (it's usually near the bottom of the list). The fourth major outperformer is Caterpillar (NYSE:CAT), which came into 2010 with the twelfth highest yield, just off the Dogs' list (its yield is usually way below, not "just under" the Dogs'.)

While the year-to-date performance of most Dow stocks has been between -10% and +10%, the performance of the four mentioned above has been a MULTIPLE of 10%, with these gains representing essentially all of the index's advance for the year. This means that the major outperformance is concentrated in relatively few hands, or has been "right-skewed" in statistical terms.

One thing that is NOT happening this year is that low yielders are compensating with capital gains. In fact, the five lowest-yielding stocks are underperforming this year. They include companies that have recently cut or eliminated their dividends, such as Bank of America (NYSE:BAC) and JP Morgan Chase, thereby indicating fundamental business weakness. But even the "natural" low yielders are not doing particularly well; Cisco Systems (NASDAQ:CSCO) is a case in point, as are Alcoa (NYSE:AA) and Hewlett Packard (NYSE:HPQ).

It's also noteworthy that a number of formerly low-yielding fast growers are now "mid-yielding," including Microsoft (NASDAQ:MSFT), Intel (NASDAQ:INTC), and Wal-Mart (NYSE:WMT), and may someday find themselves on the "Dogs" list when their relative yields "widen.

Will the most recent Dogs outperform going forward? My guess is yes, but I would look closely at the four rotators now at the bottom of the list. They are Johnson & Johnson (NYSE:JNJ), Chevron (NYSE:CVX), McDonald's (still, Boeing is now "off,") and Procter & Gamble (NYSE:PG). The six perennials dominate the upper reaches, with DuPont in more of an accustomed number six slot, instead of number three.

Disclosure: No positions