by Michael Higdon
It was a rough week in the markets, with lowered economic forecasts for growth and further strength in the U.S. dollar. The Dow Jones Industrial Average (DJIA) dropped 6.4%, the S&P 500 dropped 6.5%, and the Nasdaq dropped 5.3%. This might be a good opportunity to look for value in the market. First, we’ll look at a very easy strategy to find and implement a value portfolio. We will then look at distinctive advantages and disadvantages of the strategy.
The strategy is called the Dogs of the Dow. There are 30 stocks that make up the Dow Jones Industrial Average. The 30 stocks are first sorted by dividend yield. Pick the ten stocks with the highest dividend yield and invest equal dollar amounts in each one-- it is that simple. There is another strategy that takes this one step further-- it is called the Small Dogs of the Dow. Of these ten stocks, pick the five that are the lowest in price and invest equal dollar amounts in each one. Every year you do this to rebalance the portfolio.
The thinking behind this strategy is that every company has periods where its stock doesn’t perform well. As long as its dividend isn’t lowered, its dividend yield will go up. Since you are using this strategy on the biggest companies and ones that pay a nice dividend, the rationale supposedly is that they are the ”bluest of the blue chip stocks” and that they don’t require extensive analysis to determine if they will recover. I am not in that camp, but I would argue that they are not near bankruptcy since they are paying a nice dividend. For example, Bank of America (NYSE:BAC) is still in the Dow, but the dividend is very small since the company has had a lot of issues. I would recommend checking the stocks to make sure that they aren’t going to reduce the dividend payment. Research the recent articles written about the company to see if there is any mention of a dividend cut. If there is serious concern of a future cut, then I would not recommend buying that equity.
You might be wondering about the performance of this strategy. According to StockScreening101.com, for the years 1973 through 1991, the Dogs yielded an annual compound return of 16.6% versus the DJIA’s annual compound return of 10.4%. The Small Dogs during this same period yielded 19.4%. During this period, these strategies outperformed the market.
If you were to use the Dogs strategy now, you would end up with these stocks. Note: numbers are the dividend yields.
- Chevron (CVX) – 3.5%
- DuPont (DD) – 3.9%
- General Electric (GE) – 4.0%
- Intel (INTC) – 3.9%
- Johnson and Johnson (NYSE:JNJ) – 3.7%
- Merck (MRK) – 4.9%
- Pfizer (NYSE:PFE) – 4.6%
- AT&T (T) – 6.2%
- The Travelers Companies (TRV) – 3.5%
- Verizon (VZ) – 5.6%
If you used the Small Dogs strategy, you would get the following stocks.
- General Electric (GE) - $15.21
- Intel (INTC) – $22.16
- Merck (MRK) – $31.05
- Pfizer (PFE) – $17.45
- AT&T (T) – $27.85
There are a few advantages to using this strategy. The obvious advantage is that it is a simple strategy that is very easy to implement. It only takes minutes to calculate the stocks to invest. Since you are only adjusting the stocks once per year, it allows for a hands-off approach. The next year you would rank them again and buy the new securities that fit the criteria and sell the ones that didn’t fit it anymore. Another advantage is that it forces you to buy stocks that are “cheap.” Even though they can go lower, you are buying them after they have already declined in price and are being paid a nice dividend to wait for the recovery. Also, these stocks are not as volatile as the overall market. The Dogs have a beta of 0.868, and the Small Dogs have a beta of 0.952. A beta of 1 is the market.
There are several disadvantages when using this strategy. The first one is that there is no analysis done other than stock price and dividend. The strategy doesn’t account for growth rates, cash flow, margins, management issues, etc. It only focuses on the stock price and the dividend. Some would argue that just looking at those two characteristics is not sufficient.
The other big issue is that it is not very diversified. Of the ten stocks, five of them are either from the utilities sector or the healthcare sector. If you use the Small Dogs of the Dow strategy, of the five stocks, two of them (Merck and Pfizer) are from the healthcare sector. That is a lot of concentration in one area. Since you are only picking five or ten stocks, there is a good chance that more than one of them will be from the same sector. Generally, defensive sectors like consumer staples, healthcare, and utilities are value stocks. Most of the companies in the Dow Jones Industrial Average would be considered value stocks since they are very large companies with lots of cash and not as much growth potential as smaller companies.
I have laid out a very simple strategy to invest in value stocks. One thing to keep in mind is that past performance doesn’t guarantee future results. It has worked well in the past, but that doesn’t mean it will continue. I think that the downside is limited though, since you are buying it after it has fallen in price. It is critical that you check to see if the company might lower the dividend. Also, I do not recommend any of them individually using this strategy. For example, I wouldn’t suggest just picking out two or three out of the ten stocks without further analysis. If you are going to use the strategy, all the stocks should all be purchased to reduce company specific risk. Using the Dogs or the Small Dogs strategy is an easy way to pick out value stocks for a portfolio.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.