The “Dogs of the Dow” strategy fell from grace in the late 1990s (along with many other strategies overshadowed by Internet stocks), and it has since spent most of its time in the investing doghouse, so to speak.
However, having fared surprisingly well in retrospect during that aberrational period, the Dogs now appear to be poised for a revival. It should come as little surprise, of course, to anyone who believes in long-looking investing, that the strategy behind the Dogs has proven sound. After all, Barron's famously back-tested the strategy to 1928 and concluded that it had “the best long-term track record of any stock strategy extant.”
Still, investors are a fickle bunch, and getting them to do what is in their best interests is not always possible. With the Dogs coming back into vogue, now is as good a time as any to use them as an object lesson in why to resist abandoning a long-term strategy at the first sign of subpar returns.
The Book on Long-Term Investing
For the uninitiated, Michael O'Higgins' 1990 bestseller Beating the Dow (HarperCollins, 1991) introduced the concept of the Dogs. (I helped write the book.)
A standard Dogs strategy entails buying equal dollar amounts of the 10 Dow Industrials issues with the highest dividend yields, holding them for a year, then rebalancing annually as needed. Since yields move inverse to price, the strategy is a value and contrarian one. Soon after the book was published, Barron's coined the term “Dow Dogs” and ran a series of high-profile stories on it, including the aforementioned back-testing piece by money manager James O'Shaughnessy.
The financial services industry, to its credit, embraced the do-it-yourself system enthusiastically. A consortium of top wirehouses, led by Merrill Lynch, created unit investment trusts (UITs), called Defined Asset Trusts, holding Dogs of the Dow portfolios. Accommodating small investors, the UITs had a minimum investment of $1,000 ($250 for IRAs) and a competitive 1 percent initial sales charge that was waived the following year if funds were rolled over. A deferred sales charge of 1.75 percent of net asset value was charged from the 10th through the 12th month of a trust's one-year life. By the mid-1990s, private accounts and UITs, excluding adaptations based on the Hang Seng in Hong Kong and the London FTSE 30 index, held an estimated $30 billion to $40 billion in Dogs of the Dow portfolios.
By 1998, however, freakish, technology-led market conditions were producing mixed results in the Dogs portfolios. Investor disenchantment became evident in headlines like “These Dogs Won't Hunt.” Dogs investors lost faith in the system despite the solid logic behind its remarkable record. That the system had become too popular was the widely accepted explanation, although there was no real evidence to support it.
Faith in the Big Dogs
The Dogs system is based on the nonfinancial premise that companies of the size, strength, visibility and economic importance of the Dow components are more resilient than risky. Being run by human beings, the companies will have problems from time to time, and when that happens, the market will sell them off and make them cheap.
Still, with their immense financial and human resources and their shareholder pressure, out-of-favor Dow stocks have typically been able to report corrective progress within a year. When that happens, the market historically overreacts on the upside.
A variation on the Dogs strategy, called the Flying Five, screens the 10 highest yielders for the five lowest-priced stocks based on the “small stock effect”: lower priced stocks tend to move in greater percentage increments than do higher-priced stocks. It can be a very effective way to maximize the Dogs' returns, though it does increase risk. In the 25 years between 1973 — when O'Higgins started managing money — and 1998 — when the system began to falter — the Flying Five outperformed the Dow by nearly 60 percent, with only two loss-years, compared with the Dow's five loss-years. The cumulative average annual total returns of the basic Dogs portfolios for that 25-year period were 21.1 percent and 18.3 percent for the five and 10 stock portfolios respectively. The comparable Dow Jones Industrial Average return was 12.8 percent. Of course, to outperform the Dow is to outperform the vast majority of mutual funds.
The Recent History
After 1997, the system performed less impressively for a few years, but essentially held its own in a momentum-driven market led by overpriced growth and technology stocks. The year 2000 was a good year, with gains of 10.3 percent and 5.5 percent for the portfolios and a loss of 4.7 percent for the Dow. The portfolios had negative returns in the following two years, but they were less negative than the Dow. The years 2003 and 2004 saw a return to relative normalcy, with at least one Dogs portfolio beating the Dow each year.
With the stock market now returning to traditional valuation levels, conditions look favorable for stocks, and for the Dogs of the Dow strategies in particular. Here are some of the reasons:
Improving yields
For the Dogs, lower yields reduce the portion of the total return deriving from dividend income, which was historically about 50 percent. Anything under 3 percent for the Dow as a whole is cause for concern for Dogs investors. Lately, the Dow yield has been steadily rising; it was 2.43 percent on April 15. The average yield on the current Flying Five portfolio is 5 percent.
Repurchases on the wane
The use of corporate profits to repurchase shares rather than pay dividends, a rampant practice in the late 1990s and a serious challenge to a system based on dividend yields, proved to be a passing phenomenon. Stock buybacks make sense only when there are excessive shares outstanding, when capital gains are taxed more favorably than dividends and when a bull market exists in which higher earnings per share readily translate into share price increases. These conditions no longer prevail.
Dividend taxation reductions
The role of dividends will be greater with the recent reduction in the applicable tax rate to 15 percent and the very good prospect the dividend tax will be eliminated completely.
Return to normalcy
Earnings yields on stocks and comparable yields on corporate bonds are finally back in normal adjustment for the first time in some 25 years. The O'Higgins asset-allocation formula described in his book, Beating the Dow with Bonds (HarperBusiness, 2000), now recommends stocks over Treasury bonds or bills. He recommends the Dogs strategies, noting that while the Dow is selling 9 percent below its 2000 peak, the Flying Five are selling at roughly half their 2000 peaks.
The “New Economy” is dead
Dow price/earnings ratio, at 16.9 in mid-April, is down from 20.3 a year ago and close to the historical PE of 15. The average PE of the Dogs in a 10-stock portfolio structured now is 15.9.
In short, the Dogs have always been a good long-term play. But right now, they are a relatively easy sell even to the most shortsighted of investors.
John Downes is co-author of Beating the Dow, Barron's Finance & Investment Handbook, and Dictionary of Finance and Investment Terms. He has been affiliated with several institutions in the private and public sectors, including JP Morgan Chase, Avco Financial Services and New York City's Office for Economic Development.
[email protected]
