One trading strategy, which only requires a few minutes of work annually, has been generating annualized returns in excess of 17% per year since 1973, while the Dow has returned just 11.9% in that time period. This strategy requires nothing more than a few minutes of annualizing price and dividends, and then selecting the best investments for the money.
Dogs of the Dow
What is this simple, yet powerful strategy? Let us introduce the Dogs of the Dow strategy. This strategy was made famous by Michael O’Higgins, who argued that investors should invest in the top 10 dividend yielding stocks in the Dow Jones Industrial average.
The strategy is based on the idea that corporations do not alter dividends with year to year business cycles, and thus, dividend yields are a sign of good or bad business. While the price fluctuates with the business cycle and investment, the dividend is set by the corporation. High dividend yielding stocks are ready for a rebound in the next business cycle, moving up faster than corporations with low dividends. This assumes that the high dividends are not based on the nature of the business at hand. Financial stocks historically pay high dividends and are not exempt from this rule.
How it works
The steps are simple: at the end of trading year, review the companies that pay the highest dividend yield relative to stock prices. These stocks are typically at the low of their price trends and will advance as cycles complete. The strategy is based on the idea that good dividends mean a healthy business and future profits. More complex than the strategy might be the inner workings of why the Dogs of the Dow analysis work so well.
First, high dividend stocks are at the top of any seasoned investors list. Over the long haul, dividends add more to the returns of stocks than most would think. For example, Altria (previously Phillip Morris) is known for its high dividend yields, and since the 1960s has gone from $.07 per share to over $70 per share, a return of 100,000%. High dividend stocks are even better after considering the value in reinvestment plans. After compounding the dividend yields, Altria remains the best investment in history.
Secondly, the high dividend yields drain investments from bond investors. When dividend yields creep to levels around bond returns, money flows readily into the stock market from bond investors. This drops the dividend yield, but drives up the price of the security, where the real money is made. High dividend stocks are always in competition with low paying bonds. While bonds are historically safe places to put money, the added returns from capital gains make stocks the better investment.
Works with any index
The Dogs of the Dow strategy can be used with any large capitalization index. The strength of utilizing an index’s top 10 is that the index has already conducted due diligence for you. It takes a solid corporation to make it on the Dow Jones Industrial Average. Thus, you know that the companies in your portfolio are solid, money-earning corporations that have longevity.
Picking high dividend stocks is not a new idea, neither is only having a 10 stock portfolio; however, the Dogs of the Dow certainly struck a chord with investors. This strategy incorporates complex considerations, while putting the market in the simplest view – without much consideration for human nature. While the technical investor might find little value in this strategy, this is a proven method, and over the last 35 years, this strategy has performed significantly better than the market as a whole.
Dividend bearing stocks hold their worth much better than any other security. The dividend is a insurance plan, which ensures that even if the stock price drops, gains will be delivered to investors in the form of dividends. While some stocks could trade at P/E ratios of 5-6, it will be rare that dividend bearing stocks ever trade that low. High dividends mean investors invest heavily when stocks are cheap, raking the dividend benefits. This strategy, along with understanding of the overall markets is a great addition to any portfolio.
Consider dividing your portfolio to allow for a smaller Dogs of the Dow investment. The fixed income from dividends, plus large capital gains from rising stock prices, is the perfect blend for better asset allocation.