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Buying the "Dogs of the Dow" (the 10 highest yielding stocks in the index) is a way of trying to beat the index itself, which works some of the time (as in 2010) and not others (as in 2008 and 2009). Some people try to narrow it down to five stocks, and "beat the Dow with 5." Often, it's the five lowest priced stocks with the greatest volatility.

But we take a more reasoned approach by dividing the 10 "Dog" stocks (as of December 30th) into pairs, and then selecting the more attractive of each pair. If we can beat the "Dogs" group itself, we have a better chance of beating the Dow as a whole, if 2011 turns out to be a year when the "Dogs" underperform. The five pairs are as follows:

  • AT&T (NYSE:T), 5.86%, and Verizon (NYSE:VZ), 5.48%. The former telecom is now trading "wide" (with a higher yield) than the latter. That is usually not the case, so we pick (T).
  • Pfizer (NYSE:PFE), 4.57%, and Merck (NYSE:MRK). 4.22%. Again, the former pharmaceutical is trading "wide" of the latter. And after a 2009 cut, Pfizer's dividend is rebounding, and will likely "grow" back to over $1 a share, while Merck's has been constant for some years. So the gap between "yield on cost" will likely widen.
  • Kraft (KFT), 3.68%, and Johnson & Johnson (NYSE:JNJ), 3.49%. Two "marketing" companies with similar yields (although rather different products). But JNJ has the better franchise longer term, provided its current problems don't destroy its "brand." This is reflected in the fact that JNJ's current yield is high relative to its history, and (KFT)'s isn't.
  • Intel (NASDAQ:INTC), 3.43%, and Dupont (NYSE:DD), 3.30%. Two companies broadly serving the "capital goods" markets. DuPont is occupying its usual (eighth) place on the "Dogs" list, while Intel has never been on the list before this month, let alone as high as number seven. Intel has the better chance to see its price rise enough to take it off the "Dogs'" list, especially since its dividend is faster growing.
  • McDonald's (NYSE:MCD), 3.18%, and Chevron (NYSE:CVX), 3.14%. Two companies that are otherwise very different except for the similarity of their yields. But McDonald's dividend yield is not only nominally higher, but among the fastest-growing on the Dow. It is a fairly clear choice, unless you expect a spike in oil prices that helps Chevron (and hurts McDonald's).

Summing up, our five "Dogs" choices are:

AT&T (T)
Pfizer (PFE)
Johnson & Johnson (JNJ)
Intel (INTC)
McDonald's (MCD)

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Evaluating the 'Dogs of the Dow' Through Pairs