Sometimes, it seems as if there aren’t really any new ideas in the stock market. The Dogs of the Dow is an example of this. The Dogs is an investment strategy that is remarkably simple to implement. It requires trading once a year and has a long-term track record many active investment managers and hedge fund pros would envy. The roots of this idea can be traced back at least 60 years, a relatively old idea which means it has withstood the test of time.
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 and hold until the end of the year when you will sort the 30 stocks by yield again. Most years, you will have to replace a few stocks in the list but many names will carry over from year to year. That makes this strategy inexpensive to implement, costing less than $10 a year to trade at some of the deepest discount brokers.
This strategy was popularized in the 1991 book Beating the Dow by Michael B. O’Higgins. The book included back tested results showing the Dogs had beaten the Dow since 1973.
Of course, the idea of owning just part of the Dow, hunting for the best stocks in the index, wasn’t a new idea. The father of value investing and Warren Buffett’s investment professor, Ben Graham, touched on the idea in his classic book, 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 from 1917-1950. Schneider’s idea was to buy the 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.
- 3 Penny Stocks to Explode in America's Hottest Sector
As U.S. Defense spending hurtles towards $6.7 TRILLION, one small subset of stocks will soar... For the first time in 18 years, we're on the brink of a situation that could turn every $1,000 into $491,000. It's an historic situation, one that hasn't appeared in nearly two decades. And there are THREE penny stocks that stand to absolutely soar as this situation hits critical mass. Click here to get the ticker symbols.
Drexel & Company, a firm later known for being the issuer of junk bonds in the 1980s, picked up this topic and published a report in 1970. Their data showed buying the low P/E stocks would have beaten the market handily over many time periods. Graham summarizes one of the tests 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 as opposed to a speculation because it was built on a sound strategy. 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 from the Schneider and Drexel studies confirmed his belief.
O’Higgins put a slightly different spin in his book, using the dividend ratio instead of the P/E ratio to find the unpopular 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, pushing the prices up and generating capital gains.
Obviously, the results in O’Higgins book beat the market so let’s look at an independent test of the idea. The July/August 1997 issue of the Financial Analysts Journal, a journal Ben Graham once served as the editor of, included a long-term study. 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 or the Small Dogs of the Dow strategy invests equal dollar amounts at the beginning of each year in the five lowest priced stocks of the ten highest yielding components of 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 10.1% through the end of 2015. The Dogs of the Dow gained an average of 7.9% a year over that same time. The Dow provided an average gain of 6.3% while the S&P 500 averaged 5.8% a year over those 16 years. The table below summarizes the past five full 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. In 2016, through December 23, the Dogs have been the winner with a year to date gain of 17.0%. The Small Dogs have a gain of 11.1% and are underperforming the Dow which is up 12.7%.
For 2017, we have identified the stocks to buy for both strategies.
For the Dogs, the ten highest yielding stocks are in the next table.
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 2018 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 time frame 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. While they do not receive dividends, they obtain leveraged exposure to the stocks. For example, there is a call option on CSCO expiring in January 2018 with a strike price of $30 trading at about $2.60. If CSCO moves up to $35, this option would be worth at least $5, providing a 92% return on investment for a 14% move in the stock. It is possible using options to implement the Small Dogs or Dogs strategy could deliver a gain that beats owning the stocks even when dividends are considered.
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.