Another Look at the Cheapest Stocks in the Dow

In a recent article, we looked at the traditional approach to a trading strategy known as the Dogs of the Dow. Several readers have questioned how a simple strategy like the Dogs can work. In this article, we will explain why the Dogs of the Dow can work and look at a variation of the strategy that can be implemented at a relatively low cost.

A common question among investors is how a strategy can work when a large number of investors already know about it. Researchers have shown that if a strategy is based on sound investing principles, it can work no matter how well known it is. This idea applies to the Dogs theory which has been well known for many years. Although most investors believe the theory dates back to the 1991 book Beating the Dow by Michael B. O’Higgins, we showed in our earlier article that the strategy was actually first written about in the June 1951 issue of the Journal of Finance. Although the strategy has been available to investors for more than 65 years, it still works because it is based on sound investing principles. Those principles are diversification, time and value.

First, the Dogs is a diversified strategy with five or ten holdings. It is important to hold several stocks within a strategy because any one stock can deliver a loss. On the other hand, any stock can deliver a gain. By diversifying, investors increase the probability of owning a stock that delivers a gain.

Second, this strategy gives stocks time to go up. Over the past twenty years, as the internet allowed investors to obtain real-time quotes and place trades quickly, expectations for rapid returns seem to have become common. During the bubble of the late 1990s, some day traders believed they could consistently achieve triple-digit gains and retire after just a few years of trading. Many of these traders lost large portions of their portfolios when the bubble ended and the market crashed. Since that time, general expectations of investors seem to have become more realistic but there are still many traders targeting large gains in short time frames. This is possible with some strategies but for many investors, it could be best to take a longer term perspective like the one-year perspective of the Dogs strategy.

A longer term perspective, expecting to hold positions for months or even a couple of years, can provide individual investors with an edge over Wall Street firms. Big firms are often highly leveraged and to manage risk, they need to trade short-term strategies. They might spend millions of dollars and devote thousands of hours to develop high frequency trading strategies. Then, they spend even more money to obtain detailed market data that allows them to execute trades in less than a second. As individual investors, we simply cannot compete with Wall Street firms in this time frame. By slowing down and looking at longer term opportunities, we can compete and find market-beating returns with sound strategies.

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The rules of the Dogs of the Dow holds positions for a year, providing enough time for a stock to deliver a significant gain. And, perhaps more importantly, the rules of the strategy also prevent the mistake of taking profits early and missing out on big moves. This is a common mistake of individual investors who take profits too quickly on winning trades.

Third, the Dogs strategies are all based on value. As Warren Buffett notes, “price is what you pay, value is what you get.” We need to focus on value as investors to obtain market-beating results.

In the long run, value strategies applied with discipline and patience have been shown to outperform the market. Studies have shown this is true no matter which measure of value is used. Investors have found success buying stocks with high dividend yields, low price-to-earnings (P/E) ratios, low price-to-book (P/B) ratios, low price-to-sales (P/S) ratios and other valuation metrics.

For the Dogs strategies, investors often use the dividend yield to define value. This has the added benefit of providing income while waiting for capital gains to develop when the stock price rises. Dividends also decrease the downside of losses since the income offsets a portion of the loss.

But, the 1951 Journal of Finance article used P/E ratios and demonstrated any valuation tool could be used. This week, we looked at using the price-to-free cash flow (P/FCF) ratio and developed a low-cost Dogs strategy.

Free cash flow is the amount of cash a company has left over after paying for the cost of operations and making required reinvestments in the business. It is not a widely-followed measure like earnings or the dividend yield but FCF may be important than those metrics. FCF measures how much money the company has left over to pay for growth opportunities and to reward investors. Potential acquisitions or construction of new factories can be funded by FCF. Dividends and share repurchase programs can also be funded with FCF. Because FCF is used to fund the items that increase long-term shareholder value, it may be among the most important fundamental values even if it isn’t widely followed.

In the opinion of some analysts, FCF is the only forward-looking measure of value since earnings, book value and other items in the financial statements are all determined by what happened in the past. FCF can be thought of as determining the future. Not surprisingly, given this fact, P/FCF has been shown in academic studies to be a reliable predictor of future stock market performance.

To find our Dogs of the Dow, we sorted the stocks in the Dow Jones Industrial Average by P/FCF ratio. The five stocks with the lowest ratios made our buy list. Those stocks are The Travelers Companies, Inc. (NYSE: TRV), UnitedHealth Group Incorporated (NYSE: UNH), American Express Company (NYSE: AXP), Wal-Mart Stores, Inc. (NYSE: WMT) and Apple Inc. (Nasdaq: AAPL).

To implement this strategy, investors can buy equal dollar amounts of each stock. This can be done with any amount of capital. An alternative is to buy call options on the stocks expiring in January 2018. An option allows us to leverage an investment. Each contract covers 100 shares of stock and costs substantially less than 100 shares. However, some of these options can be expensive because the stocks themselves are expensive. To implement this strategy with call options, the contracts shown in the table below could be bought.

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Because each contract covers 100 shares, the cost of the TRV call option would be $800. Buying all five of these contracts would cost about $4,000. Smaller investors could consider buying just the three lowest priced contracts to obtain leverage and diversification.

For $4,000, you would own the equivalent of about $46,000 worth of stock. If these stocks deliver an average gain of 10%, the portfolio of five options contracts could gain more than $4,000, a potential return on investment of more than 100%.

Call options offer a low-cost way to leverage small portfolios with limited risk. The risk is always limited to the amount of money invested. Using low-priced options that expire in a year or more could allow small investors to earn large gains, in time. The Dogs of the Dow isn’t a get rich quick strategy but it is accessible to small investors and could deliver large gains over time.