There are a variety of investment strategies that are consistently beating the market in the long run. Many of these strategies are proprietary and their owners guard the secrets. They might be the work of private wealth managers or hedge funds.
But, there is at least one strategy that has beaten the market in the long run and its rules are freely available to any investor. This strategy is also simple to implement, easily maintained and within the reach of almost investor.
It’s the Dogs of the Dow strategy, a strategy that has been know about for at least 60 years and one that has beaten the market over that time. Now, in any given year, the strategy may or may not beat the market. But, investors who stick with it over time have been rewarded for their patience and persistence.
The Rules for The Dogs
The Dogs strategy has a simple buy rule. At the end of the year, sort the 30 stocks in the Dow Jones Industrial Average by yield, from the highest to lowest. Buy the 10 highest-yielding stocks at the start of the year.
The sell rules are equally simple. After making the buys, hold the 10 stocks until the end of the year when you will sort the 30 stocks by yield again. Most years, several of the previous year’s holdings will carry over and there will be just a few sells and new buys.
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That makes this strategy inexpensive to implement, costing less than $10 a year to trade at some of the deepest discount brokers.
A Long History for the Strategy
This strategy came to the individual investor’s attention in 1991 when the book Beating the Dow by Michael B. O’Higgins was released. O’Higgins shared data showing the Dogs strategy had beaten the Dow since 1973.
The idea of the Dogs has been hidden in a book written by Benjamin Graham, best known as Warren Buffett’s investment professor.
In The Intelligent Investor, Graham noted that one of his students, H. G. Schneider, published research on this topic in the June 1951 issue of the Journal of Finance. Schneider used data from 1917 to 1950 that documents a strategy of investing in unpopular DJIA issues.
Schneider’s strategy consisted of stocks with the lowest price-to-earnings (P/E) ratio. His study found that this strategy, which included buying 6 or 10 stocks, lagged the market from 1917 to 1933 but was profitable from 1933 to 1950.
Graham summarizes one of the tests of Schneider’s strategy in his book:
“The Drexel computation shows further than an original investment of $10,000 made in the low-multiplier issues in 1936, and switched each year in accordance with the principle, would have grown to $66,900 by 1962.
The same operations in high-multiplier stocks would have ended with a value of only $25,300; while an operation in all thirty stocks would have increased the original fund to $44,000.”
Graham called this an investment operation which was his term for a strategy that was reasonable to use. He split trading plans into operations (which were good) and speculations (which he considered unsound).
Under this operation, investors would be buying unpopular, high quality companies in a diversified and disciplined manner. Graham believed an operation built on these principles was likely to succeed in the long run. Data confirmed his belief with the fact that this version of the Dogs beat the Dow by 50%.
O’Higgins followed the same strategy but used the dividend ratio instead of the P/E ratio to find the unpopular, high quality stocks. The advantage of this approach is that investors receive income from the dividends, while waiting for the market to recognize the value in the stocks.
The work of O’Higgins has been confirmed by independent tests. The July/August 1997 issue of the Financial Analysts Journal included a long-term study of the strategy. In Does the ‘Dow-10 Investment Strategy’ Beat the Dow Statistically and Economically? the authors found:
“A comparison of returns from 1946 to 1995 on a portfolio of the 10 Dow Jones Industrial Average stocks with the highest dividend yields (the Dow-10) with those from a portfolio of all 30 stocks in the DJIA (the Dow-30) shows that the Dow-10 portfolio beats the Dow-30 statistically; that is, the Dow-10 has significantly higher average annual returns.”
In the paper, over the 50-year period, the average annual return for the Dow-10 was 16.8% compared to 13.7% for the Dow-30. Throughout the 50 years, the study found that much of the Dow-10 returns come from dividends, confirming O’Higgins insight that dividend yields are the best valuation tool for the Dogs strategy.
For smaller investors, there is a variation of the Dogs strategy that could be helpful to consider. The Dogs of the Dow-5 is also called the Small Dogs of the Dow strategy. It invests equal dollar amounts at the beginning of each year in the five lowest priced stocks of the ten highest yielding stocks in the Dow.
The Small Dogs of the Dow has beaten the Dow-10 strategy and the Dow since 2000 with an average annual gain of 10.5% through the end of 2017. The Dogs of the Dow gained an average of 9.5% a year over that same time.
The Dow provided an average gain of 8.1% while the S&P 500 averaged 7.0% a year over those 18 years.
The Dogs and Small Dogs are both long-term strategies. In any given year, there is no way to know which strategy will be the better performer. That means they should all be bought, and the strategy should be followed for years.
For 2018, we have identified the stocks to buy for both strategies.
For the Dogs, the ten highest yielding stocks are in the next table.
The next table shows the stocks to buy to follow the Small Dogs strategy.
Investors with smaller accounts may find the Small Dogs to be the best choice. They may also want to consider using options to implement the strategy. Instead of buying the stocks, investors could buy long-term call options on the stocks.
There are options expiring in January 2019 for each of the stocks in the Dow. These options allow investors to potentially benefit from gains in the stock price for one year, matching the timeframe of the strategies.
However, options do not pay dividends and investors would give up the ability to benefit from income with call options. With call options, investors could implement the strategy for $2,000 or less.
Although the idea of the Dogs strategy has been available to investors for decades, only time will tell if the strategy delivers market-beating results in the coming year. History does tell us this strategy gives small investors a better than average chance of beating the market pros.
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