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In the 1980s, John Slatter studied Dow stocks and found out that high dividend yielding Dow stocks have unusually strong performance. The theory is called the Dogs of the Dow Theory, and many people started to invest in the Dow stocks with the highest dividend yields. The Dow 10 strategy, which is investing in the top 10 highest yielding stocks in the Dow Jones Index, tends to outperform the overall market. From 1928 to 1997, the Dow 10 strategy generated an average return of 13.2% per year, versus 10.6% for SPY in the same period.

Professor Jeremy Siegel is also a fan of the Dow 10 strategy. In his book "Stocks for The Long Run," Siegel mentions the strategy as one of the most successful investment strategies. The truth is generally these aren't the sexy, high-flying stocks that most investors are attracted to. As a result, they trade at a discount and offer relatively higher dividends. Over time, the gap in valuation closes and these stocks outperform the rest of the Dow constituents.

In this article, we are going to discuss in detail the four Dow stocks with the highest dividend yields.

AT&T (NYSE:T) is the highest yielding Dow stock. It has a dividend yield of 5.91%. Its main competitor, Verizon Communications Inc (NYSE:VZ), also has a high dividend yield of 5.32%. We like both stocks. Both companies are exposed to the risks in the telecom industry, which is increasingly competitive and sees a growing number of acquisitions. The uncertainty in the macro-economy is another risk. If the economy is hit by another crisis, the demand in the telecom industry will shrink. Also, VZ has a relatively high debt. Its debt-to-equity ratio is 1.53 and its long-term debt-to-equity ratio is 1.40, both higher than 1.

On the other hand, the good news is that both stocks provide fat dividends and have been increasing their dividend payouts for many years. VZ has been increasing its dividends for seven consecutive years, and T has been increasing its dividends for 28 consecutive years. Both stocks are quite popular among hedge funds. There are 27 hedge funds reported to own T and 33 hedge funds disclosed to own VZ in their 13F portfolios. Cliff Asness is bullish about both stocks. His AQR Capital Management had $108 million invested in T and another $60 million invested in VZ at the end of September.

With regard to valuation, both stocks have relatively high current P/E ratios compared with the industry average. Their current P/E ratios are higher than 40, versus 25 for the average P/E ratio of the domestic telecom services industry. But their forward P/E ratios are attractive. T has a forward P/E ratio of 11.64 and VZ has a forward P/E ratio of 13.46.

Two healthcare stocks, Merck & Co Inc (NYSE:MRK) and Pfizer Inc (NYSE:PFE), also have dividend yields of higher than 4%. PFE is also one of the top five most popular Dow stocks among hedge funds tracked by us. As of September 30, 2011, there were 74 hedge funds reported to own PFE in their 13F portfolios. Ken Fisher is the most bullish fund manager about PFE. Fisher Asset Management had nearly $400 million invested in PFE at the end of the third quarter.

The average analyst recommendation score of PFE is 1.90 (1 means strong buy, 2 means buy, 3 means hold, 4 means sell, 5 means strong sell). We agree with the analysts. PFE's revenue growth is higher than the industry average. For the fourth quarter, its revenues increased by 7.5% from the same quarter one year ago, compared with 4% of the industry average. It also has a low debt-to-equity ratio of 0.46, indicating that the company has successfully managed its debt levels. It also has a quick ratio of 1.95, which means that the company is able to cover short-term liquidity needs. Moreover, PFE has a relatively low P/E ratio of 16.62 and a low forward P/E ratio of 9.18, compared with 26.33 and 10.01 for MRK.

We like PFE, but this does not mean that there is no risk investing in this company. Recently, the company lost patent protection on Lipitor, Pfizer's best selling drug. Lipitor is estimated to account for nearly 14% of PFE's total sales in 2011. The loss of patent protection means that PFE needs to achieve better revenue on other products. But we still believe PFE is able to achieve decent profits in the future by developing new products and growing in emerging markets.

The remaining six stocks in the Dow 10 strategy are General Electric Company (NYSE:GE), Johnson & Johnson (NYSE:JNJ), Procter & Gamble Co (NYSE:PG), E. I. du Pont de Nemours and Company (NYSE:DD), Intel Corporation (NASDAQ:INTC) and Chevron Corporation (NYSE:CVX). Though their dividend yields are lower than the four stocks we mentioned above, they are still yielding above the market average: all six stocks have dividend yields of between 3% and 4%. Among these six stocks, JNJ is the most popular one among hedge funds. Fifty-seven hedge funds disclosed owning JNJ at the end of the third quarter. For instance, Warren Buffett's Berkshire Hathaway had $2.4 billion invested in JNJ at the end of September. Fisher Asset Management also had nearly $700 million invested in JNJ.

Dow stocks are all quite popular among hedge funds. Most hedge funds invest in at least one or more Dow stocks in their portfolios and there are also some investors who strictly invest in mega-cap blue chip stocks. Investors do not necessarily need to employ the Dow 10 strategy, but we do recommend investors to focus on the high dividend yielding Dow stocks and do some deep research on these stocks for their portfolios.

Disclosure: I am long T.

Source: Investing In The Dogs Of The Dow