Why A Strategy That Has Outperformed Since Inception Could Do Even Better Next Year

It seems that the “Dogs of the Dow” investment strategy has been around forever, but it actually dates back to only 1991, when Michael O’Higgins first coined the phrase, then outlined it in his 1992 book "Beating the Dow." Or at least it started then under that name. The idea of buying solid, high-yielding stocks has been around a lot longer. The Dogs of the Dow simply codifies that basic idea and is now published on the website dogsofthedow.com.

It involves buying the ten stocks with the highest yields among the thirty in the Dow Jones Industrial Average at the end of each year then holding them until the end of the next year. There have been some tweaks to the strategy since its inception, of course, but that is the basic idea. Recent history suggests that it works. Since 2010, in the recovery from the recession, the dogs have outperformed the Dow Average in every year but two, and the strategy beats the Dow and S&P 500 indices over 3,5,10, and 20-year average total returns.

There are two things that make it likely to work in theory.

The first is that markets tend to be cyclical. For sure, there are some big companies that fall out of favor for good reason and never bounce back, GE (GE) would be a recent example, but the Dow is made up of thirty massive companies with a lot of staying power. Current market conditions may not suit energy companies say, or financials or whatever, but at some point, those sectors will come back into favor. Basically, buying the highest-yielding stocks in the Dow means buying value.

The second is that yield matters a lot more than most people realize. According to Hartford Funds, 82% of the total return of the S&P 500 since 1960 is attributable to reinvested dividends. That is a staggering number and a testament to the power of compounding, and it is not lost on big pension and investment funds. They rely on yield to meet their obligations and keep building their capital, but yield has become hard to find.

That is the key as to why the “dogs” strategy could do even better than its already impressive average outperformance over the next couple of years.

For pension funds, insurance companies, and anybody who depends on yield, these are tough times. We may be in a period of low inflation, but even so, a 1.8% yield on the 10-Year and 3% on AAA rated corporate bonds just doesn’t cut it for fund managers tasked with hitting target returns. Nor, with the Fed’s decision to leave rates unchanged this week and their indications that they will do nothing for a while, is that likely to change soon.

In those circumstances, the 3.955% average yield of the current dogs looks very appealing, so another year or two of outperformance has to be on the cards.

Of course, no strategy or system is perfect, and there is one scenario in which the Dogs of the Dow have underperformed. When the market crashes, as it did in 2008 and 2009, stocks in big industrial companies that are already underperforming tend to get hit harder than average. In both of those years, the strategy returned significantly less than the major indices, so if you expect a crash soon, the dogs are not for you, but then neither are stocks in general.

But if you believe that the recovery still has legs and that the Fed has learned a lesson from raising rates a couple of years ago only to then have to reverse course, the history and logic behind buying the highest-yielding Dow stocks is hard to fault.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

Other Topics

Investing