Dividend Investing Strategies – Dogs of the DOW

Dogs of the DOW is a dividend investing strategy that has shown itself to hold up over time, comparing well against the S&P 500 and DJI benchmarks.

When I was five years old I went to the dog pound with my father. I remember selecting one we called Lady (after the movie we had just seen, “Lady and The Tramp”) and she was my best friend for the next 17 years. Why is it that we have so many pejorative phrases for dogs? ‘dirty dog’, ‘gone to the dogs’, ‘sick as a dog’ – I’m just not sure how “dog” can have a negative connotation, but I’m straying.

Dogs of the DOW identifies the beaten down, problematic, downtrodden companies within the DOW. Referring to them as dogs, they are the ones that nobody wants and have been punished as a result. With redemption in mind, another descriptive phrase comes to mind – ‘every dog has its day’.

The Dogs of the DOW strategy was popularized in 1991 by Michael Higgins and works on the premise that members of the DOW are strong companies and that the ones that are currently having difficulties will rebound. The idea is that purchasing a group of hurting and unloved stocks at a time when their price is low will result in a profitable investment when the share price returns.

This is a buy low / sell high strategy that quantifies what is considered low. It is a mechanical means of selection and timing that takes judgment away from the investor, grouping companies based on specific numbers and making trades on specific days. The strategy has its critics, but its results over the years have shown that this is a successful strategy for the patient investor.

Some History

The DOW contains 30 companies selected by editors at The Wall Street Journal. The original list, created in 1896 by Charles Dow contained 12 companies that he felt offered a good picture of the American industry (thus the inclusion of the word “Industrial” in the Dow Jones Industrial Average). Over time the number of companies increased to 30, and as some companies became weaker they were removed and replaced by companies deemed to more appropriately reflect the goals of the index. General Electric is the only company that remains from the original 12.

There is no formula for inclusion in the DOW. They are large, stable, and respected companies, but no actual rules dictate a company’s inclusion or exclusion.

The Strategy

The idea of the strategy is to purchase in equal amounts the ten companies within the DOW that have the highest dividend yield on the last trading day of the year. That’s it. Companies that are already owned are held, and companies that are currently held and are no longer in the group of ten highest-yielding companies are sold.

This sounds quite simplistic and the strategy has gotten pushback because of that, but to coin yet another phrase, ‘the proof is in the pudding’. Regardless of opinion, the bottom line is the results, and they are positive. With the assumption that dividends are reinvested, according to the official Dogs of the DOW website below is a comparison of the average total returns against the Dow Jones Industrials.

It makes sense to compare this strategy against The DOW, the most commonly referenced benchmark in the world. After all, this is a selection specifically of DOW companies and its purpose is to improve on the group’s performance. I note that the longer the strategy is employed, the greater the difference in results between the strategy and the benchmark.

However, I have been comparing previous (and will continue to compare) strategies against the S&P 500. If a strategy is not able to beat the S&P 500 then it is better to simply invest in a low expense ratio S&P 500 index fund or ETF. Below is a comparison of the Dogs against the S&P 500.

This is still a favorable comparison. Had it not measured up then I would not have offered it as an option (as has been the case with some other strategies I have examined, like the dividend hedging strategy, which has an unimpressive 5-year return of -7.8% and a 10-year return of -8.0%).

When I first heard of this strategy I was intrigued. The problem was that in the 1990s discount brokers charged (at best) around $15 per trade. This meant that $150 in commissions would have been lost just getting started, and perhaps an equal amount each year to sell companies not in the new list and purchase newcomers. As I’ve always felt that one should lose no more than 1% to fees, this means it would have cost $15,000 to get started, which was a non-starter for me.

Today discount brokers, like Ally and E*Trade, offer trades without cost, so that restriction is no longer relevant. Purchasing ten companies is now within the realm of the small investor since the 1% rule can be accommodated. For $1,000 one could conceivably purchase $100 of stock of each of the ten companies, but that is hypothetical, not practical. Alas, share prices for three of the ten companies are over $100, so the lower the amount invested, the more difficulty there is buying equal amounts of each company.

I suggest one slight alteration to the current strategy if one decides to follow it as offered. If a company has seen gains and is not to be carried over to the next year then I would recommend waiting to sell it for one day. This is to ensure those gains are seen as long-term as opposed to short-term so that they receive a favorable tax status.

There Could Be Problems

This is a long term strategy. When working with a long term strategy we must have the correct mindset and realize that short term considerations can interfere with the process. There have been years this strategy has underperformed, so it will not show positive results every year.

Four of the five years between 2005 and 2009, which included a major recession, the strategy greatly underperformed the DOW. This was also the case last year. It has also underperformed when stocks have had their best years, like during the dot-com boom. So while some investors were making large sums of money, the Dogs did not offer as large windfalls.

Over the long haul Dogs of the DOW is a strong contender for a long term investment strategy that one should consider. However, there could be major bumps in the road, and one should be willing to wait out extended periods of underperformance. But isn’t this the case with many long term strategies? If one is comfortable with these shortcomings then this is a workable strategy.

Thinking Out Loud

A question I have had has been about the date selected for adding and dropping companies. It makes sense that the last trading day of the year is a convenient time to make these changes, but what if, for instance, the last trading day in June was the day to update the portfolio?

This may sound like an amusing “so what?” question, but ever since reading Outliers by Malcolm Gladwell, ideas like this come to mind. He showed that children born early in the year had a better chance to become professional hockey players than those born later in the year (sounds weird, but read the book).

In the past backtesting this sort of thing would have been impractical. But it seems to me that anyone with programming abilities and access to big data should be able to find the result. My guess is that some days might test better, but would not do so in a meaningful way.

On the other hand, there are certain times of the year that are influential when investing in the markets. Sell in May and Go Away is a well-known phrase. Though perhaps not relevant now, for many years this was a seasonal pattern that occurred every year. There is also the Santa Claus Rally, which references a seasonal occurrence.

Almost certainly the last trading day of the year was selected for the sake of convenience. This is the traditional time to reconsider one’s investments and make portfolio mixture adjustments. But my sense of curiosity makes me wonder about the timing.

I also wonder about the one-year timeframe. Certainly, it adds simplicity to the strategy, but would a holding time of six months be more profitable? How about two years? Longer?

While I know of no backtest to answer these questions there have been improvements to the strategy that I will investigate in a future article.

Finishing Up

Dogs of the DOW is a successful strategy for the dividend investor who wishes to outperform the S&P 500. It is a long-term strategy that requires patience and dedication, as it probably will not perform as well during times of great volatility. But for those who have the patience and mindset, which are terms that describe the long-term dividend investor, this strategy is a proper portfolio consideration.