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The Dogs of the Dow is an investment strategy that gained popularity in the 1990’s which proposes that an investor buy and hold the 10 stocks from the 30 in the Dow Jones Industrial Average with the highest dividend yields each year. The reasoning is that because the dividends of Dow stocks don’t vary with the price of the stock and if we believe that a company’s dividend is a good measure of the value of a company then by buying companies with a high dividend yield, we’re systematically buying those companies that are at the bottom of their business cycle and are more likely to see the stock price increase faster than their lower yielding counterparts.

The Dogs of the Dow for 2011 are :

Because of the simplicity of the strategy and its good long-term track record, it gained a lot of traction in the 90’s. A closer look at recent performance, however, isn’t as encouraging. And investors can do much better by tweaking the screening criteria. The Dogs of the Dow strategy has actually only outperformed the Dow Jones Industrial Index in 5 of the last 15 years.

I would implore any investor thinking about the “Dogs” strategy to consider an alternative Index: The Dividend Aristocrats

The Dividend Aristocrats index is a list of those S&P 500 companies that have raised their dividends for at least 25 years in a row. This is generally regarded as an important testament to a company’s business model as well as management’s commitment to returning money to shareholders. The fact that a company has been able to increase its dividend for the last 25 years says a lot about its ability to weather a recession. For that reason, a lot of the names on the Dividend Aristocrats list would probably be considered pretty “boring” companies. I featured one such company awhile back, which has increased its dividend for the last 40 years at an average annual compound rate of 14%. Coca-Cola (NYSE:KO) is another one of my favorite examples and has increased its dividend for the last 48 years. The company went public in 1919 at $40 a share. Today, each share is worth over $250,000…without dividends reinvested. With the power of compounding dividends, each one of those KO shares is now worth $8.5 million and is throwing off $243,000 a year in dividends. That’s a bit of a digression into the power of compounding dividends over time (I couldn’t help myself) and the same mechanics of dividend reinvesting are at work with the Dogs of the Dow strategy as well so this isn’t unique to the Dividend Aristocrats…but is important about the Dividend Aristocrats is that:

(i) They’re selected from a larger universe of stocks (S&P 500 vs. Dow 30)

(ii) They’re companies that have increased dividends for the last 25 years

The first point is clearly beneficial because we’re casting a wider net. But the second one is really important because consistently rising dividends over such a long period of time actually convey alot information about the underlying company and its ability to weather different economic environments as well as management’s commitment to return money to shareholders. Dividends help identify well-managed companies; every dividend declaration represents a promise by management and a vote of confidence by the board of directors in the company's leadership. This is a subtle but important bit of information.

At first glance, small dividend increases don’t look like much but when you look at the cumulative effect of them over time vs. just picking the top 10 yielding Dow stocks, the results are impressive:

I also include the Dividend Achievers Index which represents those S&P companies that have a 10-year average annual dividend growth rate. As you can see, there appears to be a clear increase in performance when the more stringent criteria (such as that for the Dividend Aristocrats) is used.

One final point – not all Dividend Aristocrats are created equal. For the “lazy” investor that wants a completely passive strategy, then buy the index. But, with a little research you can distinguish between those DAs that are worth holding for the next 25 years vs. those that aren’t.

Source: Dogs Of The Dow Vs. Dividend Aristocrats