Dogging It

If Neil Hennessy were a clothing retailer, he'd be Brooks Brothers — one of those companies whose styles don't change much, even as the fashion world decides it wants hip huggers one year and platform shoes the next. Hennessy, of course, is not a clothier. He is president of Hennessy Funds, a company based in Novato, Calif., and distinguished by its status as one of only two providers of mutual funds that maximize adherence to Dogs of the Dow investment philosophy. And his loyalty to the Dogs is making Hennessy look anything but frumpy.

You remember the Dogs. A once hot strategy of mid-1990s vintage, Dogs investors preach the purchase of stock in companies in good but temporarily under-performing stead — specifically, in the 10 top-yielding stocks in the Dow Jones Industrial Average. The idea is that, by virtue of their high dividend yields, these stocks probably are among the most depressed in the index, are oversold and are, therefore, solid values.

In the late 1990s, the Dogs snoozed as technology stocks attracted all the attention. Since then, however, the Dogs have begun to bark loudly again: Beginning in 2000, they have now out-performed the S&P for three years in a row.

Hennessy has stuck with the Dogs since they first gained notoriety. Today, he and his funds are reaping the rewards. His flagship Hennessy Balanced has returned 1 percent annually for the past three years — more than 12 percentage points ahead of the S&P.

“The Dow stocks have a long record of delivering strong returns to investors with patience,” says Hennessy.

The Dogs strategy was popularized by the 1992 book Beating the Dow by Michael O'Higgins. The book's main thesis comprised buying the 10 DJIA stocks with the highest dividend yields in equal amounts and holding them for one year; at the end of that year, an investor was to reshuffle and rebalance the portfolio, again buying the 10 stocks with the highest yields. (Usually, that meant the execution of only a few trades.) O'Higgins found that from 1973 to 1989 the strategy yielded an annual return of 17.9 percent, compared with an 11.1 percent return available from the Dow.

The O'Higgins book arrived just as the Dogs were entering a period of sharp out-performance. From 1991 to 1995, the high-yielding Dogs stocks returned more than double that of the Dow 30. Seeing the rich returns, most major brokerages, including Smith Barney and PaineWebber, began offering unit investment trusts that held the Dogs. Many brokers loved the approach, and clients trusted the familiar holdings. Most importantly, the Dogs appeared to deliver results few managers could match.

One of the biggest supporters of the strategy was the popular Web site The Motley Fool, which assured its readers that they could outperform professional investors with the simple system.

Then came the late 1990s. As value stocks lost favor, the Dogs slowed. Sales of the unit investment trusts collapsed. Merrill Lynch withdrew from the Dogs business altogether. Even The Motley Fool turned on the poor pooches, eventually declaring the Dogs a failure, perhaps because so many Dow stocks no longer paid dividends.

Through it all, Hennessy and his Dogs endured. Hennessy had steeped his clients in Dogs dicta early on and watched as the system produce solid results.

In 1996, he introduced Hennessy Balanced, the first mutual fund to rely significantly on the Dogs strategy. (Because of regulations, mutual funds cannot offer a pure play on the Dogs: To be a diversified mutual fund, a fund must hold more then 10 stocks. To satisfy regulators, Hennessey Balanced keeps half its assets in the Dogs and half in Treasury securities.)

For a time, Hennessy's fund appeared ill conceived. Beginning in 1997, the Dogs under-performed the S&P by a wide margin for three straight years. Many former Dogs enthusiasts began looking elsewhere for companionship, and Hennessy did not find many takers for his new fund. Nevertheless, he started a second fund based on the O'Higgins theory and then two more based on mechanical strategies inspired by the Dogs.

These days, performance of the Dogs — and Hennessy's funds — is exemplary. In the past two years, all four Hennessy portfolios have out-performed their benchmarks (see table). Investors have also taken notice: The fund company now oversees more than $500 million, up from less than $50 million two years ago. “This is one of most attractive times in years to buy the Dow Dogs,” Hennessy says. And if President Bush's plan to eliminate taxes paid to individuals on dividends becomes law, you can expect dividend-paying issues to become even dearer to investors.

Hennessey notes that many of the Dogs stocks offer unusually rich yields. The 4.3 percent average yield from the Dogs — higher than 10-year Treasury yields — represents a turnaround from recent years, when the Dogs generally yielded less than Treasurys. And hefty dividends from companies like Philip Morris (6.22 percent) and J.P. Morgan Chase (5.19 percent) could be a sign that now is the time to buy. “If you buy the Dogs and hold them, you will at least collect the dividend,” says Hennessy. “Stocks like General Motors could easily recover when the economy improves.”

Advisers who want to walk with the Dogs can still find a few such unit investment trusts run by companies such as Prudential and Morgan Stanley. The UITs buy the 10 Dog stocks and typically hold them for periods of between 12 and 15 months. Most Dogs trusts feature up-front sales commissions and additional fees for management as well as other charges. For example, Van Kampen Investments imposes a 1 percent sales commission and additional fees of 1.75 percent on participants in its Dogs fund.

Roy Hauswirth, chairman of Innovative Financial Group, a registered investment adviser in Brookfield, Wis., says the Hennessy funds and other Dogs investments have proved popular with clients. “The Dogs strategy is easy to understand, and it's fun to watch how the stocks perform,” he said.

Another way to benefit from the Dogs is by investing in equity-income funds, which tend to focus on high-yielding stocks. The top funds that own many Dogs in this category include Franklin Equity Income, Hartford Dividend & Growth and Vanguard Equity Income.

Hennessy agrees that equity-income funds should do well, but he argues that performance of the 10 Dogs will likely surpass more diversified choices. “Many of the Dogs stocks are deeply depressed,” he says. “By holding a concentrated group of undervalued Dow stocks, investors should get a lot of bang for their bucks.”

Funds that jump along with the Dow Dogs

Because of diversification requirements, no mutual fund can only own the Dow Dogs — the 10 top-yielding members of the Dow Jones industrial average. But these large-value funds should climb when the Dogs thrive.