Seeking Alpha

Mad Dogs Of The Dow

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Includes: AAPL, BA, CAT, CSCO, CVX, DIA, DOW, GS, HD, IBM, JPM, MCD, PFE, TRV, VZ, WBA, WMT
by: Mario Glogović, CFA
Summary

Since January, the Strategy returned 20.62% and has outperformed the DJIA index by 4.23%.

The Mad Dogs of the Dow significantly outperformed the original "Dogs of the Dow" strategy.

Dividends alone do not have predictive power as before.

To stay on the top of the game, additionally to the dividend yield, it is crucial to include the net buyback yield as the second and critical factor for market outperformance.

Currently, the combined yield (dividends and repurchases) for Dow's ten highest yielding companies is 8.57%.

Since the strategy "Dogs Of The Dow" was published, a lot has changed. For a start, dividends alone do not have predictive power as before. Presently, dividends play a supporting role and equity repurchases are the main star.

When Michael B. O'Higgins tested and popularized his idea (1991), dividends were the predominant part of cash distributions to shareholders. During the preceding decades, the average dividend payout ratio for the S&P 500 companies was around 50% of the net income. Similarly, dividends were between 70% and 80% of the total distributions to shareholders.

During late 1990, buybacks have surged and surpassed dividend payments. Since then, repurchases account for approximately 60% of the total cash distributions. For example, during the last year, the S&P 500 companies distributed 35% of the net income via dividends, and 49% via stock repurchases. The detailed statistics of the cash distributions are available on the following link.

Such structural market changes require strategy adjustments. The goal of the enhanced strategy is to harness the predictive power of net buybacks and utilize it in the separation of the top-performing companies from the underdogs. In other words, besides the dividend yield, the net buyback yield is used as a second and critical factor for the market outperformance.

At the beginning of every year, the original "Dogs of the Dow" strategy invested in the ten highest dividend yielding constituents (equal-weighted positions) of the Dow Jones Industrial Average index (DIA). After one year, the portfolio was rebalanced according to the updated list of the top ten highest yielding Dow stocks.

Between 1961 and 1998 compared to the Dow index, the outperformance of the original strategy was impressive and, on average, was 2.6% per year. Since 2000, the average outperformance decreased to approximately 1.5% per year. This decrease in the outperformance of the dividends focused strategy corresponds to the surge in buybacks.

The Mad Dogs of the Dow Strategy Significantly Outperformed the Dow Index and the Original Strategy

The enhanced "Mad Dogs of the Dow" strategy does not invest in the ten companies with the highest dividend yield. Instead, it invests in the ten companies with the highest shareholder yield (dividend yield + net buyback yield). The Strategy is based on an equal-weighted portfolio and annual rebalancing.

Since the beginning of this year, the original strategy underperforms the DJIA index by 0.51% and the S&P 500 index by 2.5%. However, the "Mad Dogs of the Dow" strategy, which invests in the top ten companies based on the shareholder yield is outperforming both indices. From the beginning of January until the end of July, the Mad Dogs strategy outperformed the DJIA index by substantial 4.23%, and the S&P 500 index by 1.73%.

Source: Portfolio Visualizer

As shown in the previous table since the beginning of this year, the enhanced strategy identified an above-average number of top performers (Mad Dog companies).

In the following table, there is a list of the Dow constituents with the dividend and net buyback yields on the first day of this year. Between the original "Dogs of the Dow" and the enhanced "Mad Dogs of the Dow" strategy, there are only three overlapping companies. These are Cisco (CSCO), JPMorgan (JPM), and IBM (IBM), while the other seven positions are different.

On the first day of this year, the average dividend yield for the Dogs of the Dow strategy was 3.77%, and the average net buyback yield was 1.82%. Thus, the average shareholder yield was 5.59%.

On the other hand, the Mad Dogs of the Dow strategy had the average dividend yield of 2.82%, and the net buyback yield of 4.52%. When combined, the total shareholder yield was 7.34%.

Although at the beginning of the year, the Mad Dogs of the Dow companies had a lower average dividend yield, the total yield (shareholder yield) was higher by 30% (5.59% vs. 7.34%).

Source: American Association of Individual Investors; Proprietary research.

A lot of companies have changed their cash distribution channel from dividends to repurchases to reward investors with a more favorable tax treatment. Thus, by selection companies purely on the dividend yield, one misses companies that distribute high amounts of cash via equity buybacks.

For example, by selecting companies purely on the dividend yields, one would miss Apple (AAPL) and Goldman Sachs (GS), which are at the bottom of the original strategy. However, when stock repurchases are taken into account, they are one of the top cash distributors. Since the beginning of the year, with 36.17%, Apple was the top-performing stock of the Dow index. Similarly, Goldman was in the top five performers.

Additionally, the Mad Dogs strategy avoided companies like Verizon (VZ) and Chevron (CVX). These companies, on the one hand, return cash to shareholders via dividends, but, on the other hand, dilute them via stock issuance.

Below is the comparison test of Dogs of the Dow (Portfolio 1) and Mad Dogs of the Dow (Portfolio 2).

At the beginning of 2019, $1,000 invested in Dogs of the Dow resulted in $1,159 at the end of July. During this period, the maximum drawdown was 4.70%, and the standard variation was 12.56%. On the flip side, $1,000 invested in the Mad Dogs resulted in $1,206 at the end of July. However, the maximum drawdown (-6.35%) and the standard variation (20.62%) were both higher.

Source: Portfolio Visualizer

During the first seven months of 2019, on $1,000 invested, dividend income for Dogs of the Dow ($23) was higher compared to the Mad Dogs strategy ($16). However, dividends are only one component of the total return, which was significantly higher for the Mad Dogs of the Dow strategy.

Source: Portfolio Visualizer

Updated List of the Mad Dog Companies

An updated table with ten Mad Dog companies is available in the following table. Anyone that wants to utilize the Mad Dogs of the Dow strategy does not need to wait until the next January. Monthly, I will publish the top ten constituents, so the updated Mad Dogs list will be available for new investments or the annual rebalancing.

Source: American Association of Individual Investors; Proprietary research.

Compared to the beginning of the year, four companies were excluded from the Mad Dogs list. These are McDonald's (MCD), Goldman Sachs (GS), Travelers (TRV), and Walmart (WMT). Four new companies that entered the list are Pfizer (PFE), Caterpillar (CAT), Home Depot (HD), and Dow Inc. (DOW). Six companies that staid on the list are Walgreens Boots (WBA), Cisco Systems (CSCO), IBM (IBM), Apple (AAPL), JPMorgan Chase (JPM), and Boeing (BA).

Compared to the beginning of the year, the average dividend yield for the ten Med Dogs has increased from 2.82% to 3.51%, and the average net buyback yield has risen from 4.52% to 5.06%. Consequently, the combined yield (shareholder yield) has increased from 7.34% to 8.57%.

For the Dow Jones Industrial Average index, the average net buyback yield and the average shareholder yield are significantly impacted by Disney's total outstanding share increase. In this case, the median buyback yield and the median shareholder yield are better proxies for comparison to the Mad Dogs strategy.

Source: American Association of Individual Investors; Proprietary research.

Strategy Risks

Compared to the DJIA index, this strategy has a much more concentrated allocation. The Mad Dogs of the Dow exposure to the single stock is 10% compared to on average 3.33% for DJIA constituents. However, due to the Dow's price-weighting methodology, its single stock exposure could be significantly above the average. Similarly, for the Mad Dogs strategy, the exposure to one sector or industry could be significantly higher compared to Dow's exposure.

On the one hand, a more concentrated portfolio with a much higher shareholder yield could be a source of significant outperformance. Yet, on the other hand, it is a source of the additional risk, which could lead to considerable return differences compared to the DJIA index. Additionally, this strategy is not focused on the minimization of the tracking risk. Instead, it focuses on the long-term absolute outperformance.

If you plan to use any part of this strategy, it is essential to adjust percentage equity allocation and the number of equity positions in your overall portfolio according to your willingness and ability to tolerate risk.

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Additionally, feel free to post comments regarding what you would like to see in subsequent updates.

Until my next article, be patient with your investments and give them time to grow!

Disclosure: I am/we are long AAPL, IBM, DOW, BA, WBA, CSCO, PFE, CAT, JPM, HD. 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.