Trade the Dogs of the Dow Strategy Using a Discount Shopping Strategy

You might be familiar with the Dogs of the Dow, a popular investment strategy that identifies stocks in the Dow Jones Industrial Average offering the best value. The strategy was first detailed in a 1991 book, Beating the Dow by Michael B. O’Higgins.

The strategy buys the ten highest yielding stocks from the thirty stocks that are included in the DJIA and trades just once a year. These ten stocks are known as the Dogs of the Dow. Theoretically, high dividend yields are a sign of value in stocks as long as the dividend is safe. Large caps stocks included in the Dow are most likely safe and the committee that selects stocks for the index would almost certainly remove stocks before they fell into severe financial distress.

Dividend yields are usually viewed as providing information about income and most investors view them as an income screening tool. But in this strategy, dividend yields are identifying value just like the price-to-earnings (P/E) ratio or other popular ratios would. When yields are used for valuation, the idea of relative valuation is being applied. We are not concerned with whether the yield is 1% or 10%. We are looking for the highest yields in a group of stocks that all pay a dividend. Since each of the Dow stocks is an income stock, the dividend yield is a way to sort them and identify the most undervalued or overvalued stocks. This approach only works when applied to groups of stocks that all pay a dividend that is reasonably safe so yields have limited use in valuation screens.

Under the Dogs of the Dow strategy, in any given year some of the stocks should deliver market-beating gains, some will provide an average return and some will experience losses. Big winners are expected to significantly outweigh the losses. In the long run, the Dogs of the Dow strategy is expected to outperform the index.

Results presented in the book showed simply buying ten stocks and trading once a year did in fact significantly outperform the market. Following the strategy from 1973 to June 1991 would have resulted in a total return of 1,753%, more than three times better than the gains of the Dow which returned 559% over that same time. That’s an annualized rate of return of 16.61% for the Dogs and 10.43% for the index. In the years since publication, the strategy has remained popular even though it has not really delivered the same types of gains. In some years, the strategy outperforms and in other years the average does better than the Dogs. Since 2000, the Dogs have slightly outperformed the Dow, gaining an average of 7.7% a year while the Dow is up an average of 6.2% a year. Over other time periods, the track record is mixed.

Given the fact that the performance is so similar to the index in many years, some investors have looked for variations on the idea. Their thinking seems to be that the Dogs did so well in the original test there must be a way to succeed in the future.

One popular variation of the strategy is to buy only the five lowest priced stocks from the list of the ten high yielding stocks. This variation is sometimes called the Small Dogs of the Dow and after delivering great returns in the initial test period, it has also delivered mixed returns since publication, beating the Dow in some years and lagging in others.

Following the basic strategy involves investing an equal amount of money in each of these 10 stocks, or 5 stocks in the case of the Small Dogs, once a year and holding them for one year. You can buy the Dogs or the Small Dogs anytime during the year and hold for one year before rebalancing or you can even rebalance two or four times a year. In the long run, the results are about the same no matter what time of year you start or how many times you rebalance the portfolio. However, given the high price of Dow stocks and the mixed record of success, this strategy might carry a high opportunity cost for smaller investors.

Opportunity cost can be defined in many ways and economists have developed a precise definition of the term. I am defining opportunity cost as the cost of owning an underperforming investment. For example, if you own a stock that gains 10% while the Dow rises 20%, your opportunity cost is 10%. To me, that 10% gain would actually represent a loss of 10% since it underperformed the market.

There is one way to minimize the opportunity cost and that is to use call options to buy call options instead of stocks.

To implement the Small Digs strategy now, you would buy:

  • Cisco Systems, Inc. (Nasdaq: CSCO), a company that designs, manufactures, and sells Internet Protocol (IP) based networking products, as well as other products within the communications and information technology industry around the world.
  • Pfizer Inc. (NYSE: PFE), a biopharmaceutical company that discovers, develops, manufactures, and sells its healthcare products worldwide. PZE operates through Global Innovative Pharmaceutical (GIP); Global Vaccines, Oncology and Consumer Healthcare (VOC); and Global Established Pharmaceutical (GEP) segments.
  • Verizon Communications Inc. (NYSE: VZ), a company that provides communications, information and entertainment products to individuals, businesses and governmental agencies worldwide.
  • JPMorgan Chase & Co. (NYSE: JPM), a financial services company that operates through Consumer and Community Banking, Corporate and Investment Bank, Commercial Banking, and Asset Management segments worldwide.
  • Caterpillar Inc. (NYSE: CAT), a company that manufactures and sells construction and mining equipment, natural gas and diesel engines, industrial gas turbines, and diesel-electric locomotives worldwide. CAT also provides equipment and related parts for both general and heavy construction, rental, mining, quarry and aggregates markets.

These are large, well-known companies with safe dividend yields. To achieve the returns of the Dogs, you would need to buy an equal number of shares in each company. Buying 100 shares of those five stocks would cost $25,790. This is a fairly large amount of money for many investors and investing in this strategy almost guarantees you won’t have any really big winners. These are large cap stocks which tend to move in line with the broad market. In a best case they might double the market return. As small investors, we often want larger gains than that and look at small caps or growth stocks to earn big gains.

Rather than allocating so much money to a strategy likely to deliver average returns, we could use the Dogs as a way to attain average results in part of our portfolio using options to lower the costs. To do this, we could look at the following specific trades right now, using long-term calls that are trading close to the stock’s current price:

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Buying these five call option contracts would cost about $1,785 (each contract controls 100 shares of the underlying stock). Because these five option contracts would cost just 7% as much as buying 100 shares of each of the stocks, traders can commit a smaller amount of funds to this strategy.

That leaves more than 90% of the capital needed for the Small Dogs strategy free for finding other opportunities, while this strategy is likely to deliver market-beating gains on a small part of your capital.

Perhaps most importantly, risk is limited with options. You can never lose more than you pay for an option. If there is a bear market soon, investors following the Small Dogs stocks are likely to lose much more than $1,785 on their investment, while this option strategy can never lose more than that in dollar terms.