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By Brian Tracz

You are reading this article because you want good stock picks. For those who are less interested in alpha and more interested in simply beating the major indices, the Dogs of the Dow strategy is an intriguing investment procedure. Better yet, it picks the stocks for you. The strategy, developed in the 1990s by Michael Higgins in his book Beating the Dow, is simple: (1) Invest in the 10 highest dividend yielding stocks of any given year (2) Readjust yearly (3) Watch your stocks beat the Dow. And there's some truth to this strategy since, from 1973 to 1996, the Dogs beat out the rest of the Dow by 4.5 percent.

The thesis behind this strategy is that companies with the highest dividends in the Dow will usually be underpriced but overall stable businesses. You are thus rewarded with better capital gains, higher dividend yields, and added stability for your stock portfolio--a three-for-one deal. If you were to build a "Dogs of the Dow" portfolio right now, what would be in it?

Let's take a look. Here are the Dogs, with annualized dividend yields:

Company

Price ($)

Dividend Yield (%)

Verizon (VZ)

44.46

6.4

AT&T (T)

36.3

6.2

Pfizer (PFE)

23.49

4.5

Merck (MRK)

43.33

4.3

Du Pont (DD)

48.77

4

Kraft Foods (KFT)

39.38

3.9

Chevron (CVX)

108.27

3.8

Johnson & Johnson (JNJ)

68.74

3.8

Intel Corporation (INTC)

25.5

3.4

General Electric (GE)

20.56

3.3

There are some general remarks about this portfolio's year-to-date performance. First, the portfolio has indeed outperformed the Dow and S&P 500 in 2012 in respect to capital gains. An equally-distributed investment in the Dow 30 returned 5.5 percent, whereas an equally-distributed investment in the Dogs of the Dow returned 9.3 percent. An S&P 500 index fund would have returned about 8.1 percent. But the Dogs of the Dow, remember, will have a higher dividend yield than the other broad indices, giving it an upper edge in terms of total return.

Not surprisingly, broad-based investors and hedge fund managers are attracted to many of these stocks. As of March 31, Adage Capital, managed by Phil Gross and Robert Atchinson, holds General Electric, Chevron, Verizon, and AT&T in its top 12 holdings - impressive considering the fund has over 200 holdings (you can view the portfolio here). I couldn't really fault anyone who holds any one of these stocks long.

That said, you might be passing up opportunities if you strictly follow the Dogs of the Dow strategy. For instance, GlaxoSmithKline (GSK) and Bristol-Myers Squibb (BMY) are both stocks that meet the theoretical desiderata of the Dogs strategy. They actually have lower betas (they are less volatile), lower lagging P/Es, and higher dividend yields than both Merck and Pfizer. So these two stocks "look" better if you were to assemble a portfolio right now. GlaxoSmithKline is still a growing company, acquiring Human Genome Sciences (HGSI) for $3.8 billion earlier this month. Then again, Merck and Pfizer have enormous product lines that would resist major economic strains or single-product issues--the Dow Jones was meant since its inception to choose stocks based on the solidity of their brands and the quality of their businesses.

On July 24, Du Pont beat the Street's earnings projection for the second quarter by 1.4 percent at $1.48 per share. Like Chevron, Du Pont has a business that is closely tied to the broader manufacturing and production sectors and is, therefore, more heavily exposed to macroeconomic sways. To balance this, Waste Management (WM) makes a good hedge for a Dog strategist--it has a flat share price, a business with few direct competitors, and a 4.3 percent annual dividend. Its major risks revolve around margin fluctuations and less around economic sentiment.

Source: How Are The Dogs Of The Dow?