Dividend Dogs Vs. Index - Episode 1

Includes: AAPL, IBM, T, VHDYX
by: Christopher Price

Perhaps the greatest investor of all time, Warren Buffett, recommends investing in index funds for retirement.

Another popular strategy recommends investing in dogs - solid companies that have performed below the market.

In this hypothetical scenario, two small-time investors will start with identical nest eggs to begin investing, one with each strategy.

This experiment will last at least one year, with monthly updates coming.

Warren Buffett is widely hailed as one of the best investors of all time. The Oracle of Omaha recommends that laymen opt for index funds when saving for retirement. He argues that the index returns are generally better than most actively managed funds over time and those actively managed funds have high fees because they have professional managers. These fees cut down on the performance even more.

Another popular strategy was first popularized by Michael O'Higgins. This is the Dogs of the Dow strategy, and it recommends buying components of the Dow Jones Industrial Average that have the highest dividend yields. He recommended purchasing an equal amount at the beginning of each year with the same strategy - buy the 10 highest-yielding stocks on the Dow. He estimated that this would provide higher returns over time.

For the following hypothetical test, I plan to track two investors. I will name them Bob and Bill. Both Bob and Bill had $3,000 to invest as they've been saving up to invest in one of Vanguard's index funds. Bob decides to go with the index fund, but Bill decided that he might be able to beat the index after deciding to invest in the Dogs - attractively priced dividend-paying stocks. Both will have $3,000 to invest as they've been saving up to invest in one of Vanguard's index funds. Bob decides to go with the index fund, but at the last minute, Bill decided that he might be able to beat the index after deciding to invest in the Dogs - attractively priced dividend-paying stocks. He won't invest at the beginning of each year, but as he accumulates $1,000 to put toward another company.

Both are small-time investors. They have $200 available each month to invest after paying all of their bills. This $200 will be automatically deducted from their checking accounts so that they will not forget to save. Bob will put that $200 into his index fund on the first trading day of each month. Bill will wait until he can purchase $1,000 or thereabouts so that he can keep his trading costs down. I will assume that Bill uses a low-fee broker that charges only $4.95 per trade. He will not automatically reinvest dividends but will instead hold onto them to reinvest into attractively priced stocks at the time that he is ready to invest. Both are looking to build up an income for retirement from dividends and distributions. Here are how they decided to invest on the first trading day of 2019.

Bob's Index Investment

Bob, as noted above, decided to invest in an index fund. To increase the amount of income that he could realize, he decided to invest in Vanguard's High Dividend Yield Index Fund (VHDYX). The minimum investment is the $3,000 that he has available, so he does not have to wait around to invest.

Bob finds the 3.5 percent yield attractive, and he decides to automatically reinvest the dividends that his stake pays out until he can retire. Then, he'll use the dividends for living expenses. Without reinvestment, a 3.5-percent dividend yield would pay out about $105 over the course of a year. On January 2, 2019, the price of a share of VHDYX was $30.94. This meant that Bob could buy 96.9619 shares of the fund. He will hold onto this throughout the experiment. Since he's an index investor, there's little need for additional analysis at this point.

Bill's Dogs

Bill will make three separate purchases of just below $1,000 and will pay $4.95 per trade. Therefore, on January 2, he will have three holdings of about $1,000. Because he is attempting to grow dividend income, he will limit his investment to dividend-paying stocks.

Bill decides that he will not limit his analysis to the Dow Jones Industrial Average, but he will attempt to find attractively priced stocks that have high yields. He decides to go outside of the Dow because he wants to invest in AT & T (T). He's read that this is one of the most popular dividend-growth stocks around and appreciates that its payout has grown for more than three decades straight. While the stock was a bit off its low on January 2, he saw the company's really low PE ratio that's currently around 6 combined with a dividend yield of around 7 percent (6.91 percent as of January 2). He believes that AT&T will be a low-growth stock, but the cash that it pays out will allow him to buy additional shares of T or another stock more quickly. All stocks in Bob's and Bill's accounts will be purchased at the closing price for the day.

The price that AT&T shares fetched at the close of trading on January 2 was $29.54, which means that Bill can purchase 33 shares. When adding the $4.95 to the purchase price, Bill paid $979.77 for his shares of AT&T. These shares will pay out $0.51 per share per quarter based upon the latest dividend increase which will hit with the February payment. This provides him with an estimated $67.32 in dividend income over the next year.

Bill next decided to invest in Apple (AAPL). This computing and smartphone giant has been in the dog house with investors recently. They've had to cut back on production, and sales have been a bit sluggish. As a result, the stock price fell from a 52-week high of $233 to a 52-week low of $142. This brought the stock's yield to slightly above 2 percent. Unfortunately, the 52-week low hit a day after Bill's investment, so he paid quite a bit more. His price for AAPL was $157.92 per share. His entry yield was 1.85 percent, which is much higher than the ~1.2 percent yield that Apple had at its high for the past year.

Over the past FY that ended in September, Apple earned $11.91 per share, which meant that its PE ratio was right around 12 when Bill made his purchase. Additionally, its dividend payout ratio is currently less than 25 percent of 12-month trailing income. Bill was able to purchase 6 shares of AAPL, and when transaction fees were included, he paid $952.47 for his purchase. Apple's annual dividend payout is $2.92 per share, which means that Bill's 6 shares should pay out at least $17.52 over the next year. This number should go up, as Apple has been increasing its dividend payment and its payout ratio is quite low.

For his last purchase, he decided to follow the Dogs of the Dow strategy and buy IBM (IBM), which is the Dow component that is currently the highest yielder on the Index. He looked at the payout ratio that's quite sustainable. IBM had earned $7.37 over the first nine months of the year while paying out only $4.71 in dividend payments over the same period. There has only been one quarter over the past three years in which quarterly income failed to meet the dividend payout, so Bill looks at this as a fairly safe investment.

The price of IBM on January 2 was $115.21, which means that Bill could purchase 8 shares. His total cost when including the $4.95 fee for the 8 shares of IBM was $926.63, which should pay out $50.24 over the next year (8 shares X $6.28 dividend/share).

After the purchases on January 2, the respective portfolios look like this:

Bob's Index

Investment Shares Price Per Share Value
VHDYX 96.9619 $30.94 $3,000.00

Bill's Dogs

Investment Shares Price Per Share Value
Apple 6 $157.92 $947.52
IBM 8 $115.21 $921.68
AT&T 33 $29.54 $974.82
Cash $141.13
Total Account Value $2,985.15

The account values are different because of the transaction fees that are deducted from the individually managed account that Bill holds. On the first trading day of February, there will be an analysis of the two accounts with the $200 monthly investment added into the equation. I appreciate your support.

Disclaimer: I am not an investment professional. The preceding is intended for informational and educational purposes. Please make sure to perform due diligence before investing in equities, as losses up to all capital invested can occur.

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.