Make Your Dogs Of The Dow Howl

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Includes: CSCO, KO, MO, PFE, VZ
by: Steve Auger

Summary

The Dogs of the Dow is a popular investment strategy that has been around for more than 25 years, and in need of a makeover.

A modified Dogs of the Dow strategy with superior performance was presented, and 10 stocks were selected, based on the strategy.

The 5 lowest price stocks were chosen from the top 10, similar to what is done with "Small Dogs of the Dow".

Return on Equity, Free Cash Flow, and cash were examined for CSCO, PFE, KO, VZ, and MO. All five stocks were found to have very good fundamentals.

CSCO was identified as the best stock to own. MO would draw the short straw if one stock had to be discarded.

The Dogs of the Dow is a popular investment strategy that has been around for more than 25 years. Popularized by Michael B. O'Higgins in the book Beating The Dow, the strategy selects the ten Dow Jones Industrial Average (DJIA) stocks with the highest yield at the beginning of each year. There are proponents and critics of the strategy and this article is not intended to defend or criticize the strategy. Dogs of the Dow was unleashed on the public in 1991, long before stock market tools and market data were readily available. I figured it was time that I try to make some improvements with today's state of the art tools. I would like to note here that O'Higgins has made modifications to his original strategy, including Beating the Dow With Bonds, which has the investor fully into stocks or fully into bonds, based on the market's earnings yield (inverse of the P/E ratio) and the price of gold. I won't be chasing these modified strategies, but starting from the original.

I use Portfolio123 for most of my work developing stock market strategies and used it for this project. My first task was to capture the very simple rules and run a backtest. In so doing, I made a refinement to the original strategy, not an improvement, but a change to make the strategy easier to program using Portfolio123. Instead of reconstituting the portfolio holdings the first day of each year, my strategy updates the holdings on the first Monday of the year, or Tuesday if Monday is a holiday. The chart below shows the performance of the Dogs of the Dow strategy since the beginning of 1999.

Performance of Dogs of the Dow (Original)

The first change that I made to the original strategy was to rebalance quarterly, instead of yearly. There are two reasons for this. The first reason is that the performance is a little better than holding the original positions for an entire year. The second reason is that quarterly rebalance makes it practical to change the decision-making algorithm periodically as market conditions change. I will describe this in more detail later.

Performance of Dogs of the Dow with 3-month rebalancing

New Strategy

With the portfolio designed for 3-month rebalance, it is now possible to implement logic that decides whether to follow the Dogs of the Dow "highest yield" strategy or another strategy, on a quarter-by-quarter basis.

I decided to use the 3-month change in the US unemployment rate to make this determination. If the unemployment rate is decreasing, then the algorithm chooses the 10 highest yielding stocks from the DJIA. If the unemployment rate is rising, the algorithm chooses the 10 highest ranked stocks from a standard ranking system provided by Portfolio123, called All-Stars: Greenblatt.

Greenblatt's Magic Formula

The ranking system, named after Joel Greenblatt, is based on his book "The Little Book that Beats the Market". In the book, Greenblatt suggests purchasing cheap stocks with a high earnings yield and a high return on capital.

High earnings yield, as implemented by Portfolio123, is:

Operating Income After Depreciation / Enterprise Value

High return on capital, as implemented by Portfolio123, is:

Operating Income After Depreciation / (Receivables + Inventory + Net Plant Assets)

The chart below shows the backtest performance of the new strategy and original Dogs of the Dow system. The new strategy handily outperforms the original.

Performance of the new strategy and Dogs of the Dow

The annualized return for both the Dogs of the Dow and the new strategy are summarized below.

Annualized returns, 1999-2016

The current holdings, selected at the beginning of January, are listed in the table below.

10 stock holdings based on new strategy

Ticker

Recent Price

Sector

Yield

CSCO

$30.10

Info Tech

3.46

PFE

$31.77

Health Care

4.03

KO

$41.32

Staples

3.39

VZ

$52.72

Telecom

4.38

MO

$70.01

Staples

3.49

XOM

$85.89

Energy

3.49

CAT

$94.58

Industrials

3.26

CVX

$115.60

Energy

3.74

BA

$159.53

Industrials

3.56

IBM

$170.55

Info Tech

3.28

At this point in time, I would like to point out that there is a "Small Dogs of the Dow" strategy, that chooses the 5 stocks with the lowest prices from the original 10 selections. So instead of stopping at 10 stocks, I am going to choose the 5 with the lowest price. These are: Cisco Systems, Inc. (NASDAQ:CSCO), Pfizer Inc. (NYSE:PFE), The Coca-Cola Company (NYSE:KO), Verizon Communications Inc. (NYSE:VZ), and Altria Group, Inc. (NYSE:MO).

Top 5 stocks - Market Cap, Return on Equity, Cash, and Free Cash Flow

Ticker

MktCap

ROE

Cash&Equiv

FCF

CSCO

$151.2b

17.23%

$71.0b

$7.4b

KO

$178.2b

27.68%

$25.6b

$2.0b

MO

$136.60

178.70%

$2.3b

$0.6b

PFE

$192.80

9.51%

$14.4b

$5.7b

VZ

$214.9b

83.48%

$6.4b

$2.4b

The top 5 stocks have strong balance sheets and free cash flow. If I had to discard one of these stocks, it would be MO, since it has the lowest level of cash and free cash flow. If I could only select one stock, it would be CSCO, not only for the company's massive stash of cash and strong free cash flow, but also because of the price chart, which is bullish.

CSCO stock chart

The next rebalance period is the first week of April. I will follow up with a new article at that time.

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

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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