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The Dogs of the Dow: Investing Made Easy

Michael Kahn, Contributing Writer, Kiplinger.com

January is the time of year when gurus offer their forecasts for the year ahead. It's also when they encourage you to examine your investing strategies, and time after time, the "Dogs of the Dow" makes headlines. We'll get into the details in a moment, but in short, the appeal is simplicity - just a few simple rules and no further action until next January. Set it and forget it.

Investing can be daunting with all the choices now available. Stocks, bonds, real estate, cryptocurrencies - the varieties are endless.

For most people, stocks have a place in the portfolio, but which stocks? You can buy an index fund and simply ride along with the market. However, if you want to do a little better than simply "market performance," you need to have a strategy.

Strategies can be complicated. Some rely on financial analysis of a company's balance sheets. Some screen stocks by management style and others by changes in demographics and social trends. And some look at charts in an attempt to find where other investors are putting their money.

But there are simpler methods.

SEE ALSO: The 18 Best Stocks for 2018

Enter the Dogs of the Dow

The Dogs of the Dow strategy is a popular approach to picking stocks that are likely to outperform the market in the coming year. Based on the component stocks of the Dow Jones Industrial Average, it calls for investing equal amounts each January in the 10 Dow stocks with the highest dividend yields, and holding them until the following January.

Why dogs? Because the highest-yielding stocks in the group theoretically did not fare well in recent months. Even with the actual dividend payout remaining the same, dividend yields rise as price falls due to the math. But the higher-than-usual payout suggests they have the most room to rebound, and thus outperform the market.

One bonus is that the candidate stocks are all blue-chip large companies that have been around for quite a long time, making them fairly safe plays.

There is an auxiliary strategy called the Small Dogs of the Dow and it adds one additional screen. Of the 10 highest-yielding stocks at the start of the year, it selects only the five with the lowest dollar prices. The theory here is that low-priced stocks also have room to rally, giving the Small Dogs even more potential for gains.

Here is a table of recent performance (sourced from the DogsoftheDow.com):

As you can see, over the long haul, the Dogs do beat the market by a respectable amount. For instance, while DogsoftheDow.com hadn't yet listed 2017 on its performance tables, we know that the Dogs returned 19.5% before dividends and the Small Dogs returned 8.7%, vs. the Dow Jones Industrial Average's price gain of 25.1%. It was not a good year for the strategy.

Its worst performances occurred during the dot-com boom of the late 1990s as technology stocks that paid little or no dividends soared while large industrial stocks lagged. For example, in 1998, the Dogs gained 7.8% while the Dow gained 16.1% and the tech-heavy Nasdaq gained 39.6%.

During bear markets in general, stocks that have fallen on hard times - and likely qualify as Dogs - are more likely to stay weak. Stronger stocks will tend to resist the bear better and bounce back sooner once the market stabilizes

The question is, how do you know when to apply the Dogs strategy and when to stay away?

Flaws in the Theory

The biggest flaw in any portfolio rebalancing strategy is the concept of rebalancing itself. While it makes sense to pare back a position in one stock that soared higher in price because it represents too great a percentage in a portfolio, doing so violates a major rule of investing and trading. The rule of thumb is to cut your losses and let your winners ride. Selling winners because they grew to a high percentage of a portfolio does the reverse.

During bear markets, a typical strategy to keep a portfolio at certain percentage weightings also can result in adding the weakest stocks, further compounding the effects of the falling trend.

SEE ALSO: 50 Dividend Stocks You Can Count On in 2018

During the financial crisis of 2008, let's say you owned only two stocks in equal weights - a bank and a biotechnology company - and rebalanced your portfolio every month. The bank stock fell much harder than the biotech, so your portfolio became too heavily weighted toward the biotech. By selling some of the biotech and buying more of the bank, you put your portfolio at even more risk, not less.

Therefore, a simple check of a chart to see which potential dogs are in rising trends and which are in falling trends can be a good filter.

Modifications

The Dogs of the Dow has a few other problems. For example, Investment Quality Trends editor Kelley Wright believes that relative dividend yield, not absolute, is more important. Rather than just compare one stock's yield to another's, investors should look at how a stock's current dividend yield compares to its own history. Is it paying a higher yield relative to its past? If so, it could be undervalued and ready to rally.

Comparing the dividend yield of a bank to an oil company is not necessarily an accurate marker for valuation. Some sectors naturally return less of their profits to shareholders in the form of dividends.

Alex Reisman, co-proprietor of StockRover.com, wrote that to have a true value-oriented strategy, the Dogs should look at forward price-to-earnings ratios (based on estimates for next year's profits).

For investors who really want to crunch the numbers, they can combine both of these changes and look at P/E ratios within their recent ranges. Is the forward P/E for a given stock near the top or bottom of its five-year range? If it is near the top of this measure of valuation, it likely won't have "catching up" as an engine for price gains.

Another slant on the Dogs modification comes from Larry Williams, veteran trader, author and proprietor of IReallyTrade.com, who calls his version "Darlings of the Dow." Instead of dividend yield, he looks at the five Dow stocks with the lowest price-to-sales ratios. He prefers P/S to the more familiar P/E, as the latter is often subject to manipulations and one-time special situations such as asset sales.

Williams further screens his Darlings by making sure these stocks have a bright future in the form of forecasts for positive earnings growth over the next 12 months. With this added criterion, his group of five beat the regular Small Dogs strategy in 2017 with a gain of 22.1% vs. 8.7%. However, although this method has beaten the market by several percentage points over time - including an excellent win streak between the late 1970s and early 2000s - it did not beat the Dow last year.

Any strategy will have its ups and downs. One important point to make is that in 2017, the Darlings produced no losers while the Small Dogs had two stocks that lost ground and the full Dogs had four losers. Put another way, both Dogs versions lost money on 40% of their investments while the Darlings produced all winners.

Keep It Simple, Smarty

The idea of the Dogs of the Dow is to make stock picking easy and relatively safe, the latter because the universe is limited to blue-chip stocks.

This year's Dogs are (with recent prices and dividends):

What will that get you this year? Oils, drugs, non-glamorous tech and a little consumer. Last year's worst Dow performer, General Electric (GE), barely makes the cut at No. 10, but that's thanks to a dividend cut announced in 2017.

What else do you get? Dividend income, something that has been scarce in the post-financial crisis world of low, low interest rates.

So far, only four of this year's crop is beating the full Dow Jones Industrial Average. But it is early and this strategy is designed to outperform over the course of 12 months, not just a week or two.

SEE ALSO: The 9 Best Dividend Growth Stocks in the Dow

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