The Dogs of the Dow
DJIA Value Investing

The Dogs of the Dow is a large cap value investing strategy focused on the 30 stocks of the Dow Jones Industrial Average (DJIA). Popularized by Michael O’Higgins (he didn’t call it Dogs of the Dow) in his 1992 book, Beating The Dow, the strategy is offered in many online stock screeners as a predefined screen.

As a value investing strategy, this is as simple as it gets.

To screen for the Dogs, sort the 30 stocks of the DJIA by their dividend yield and buy the top 10 in equal dollar amounts. That is simple.

One year later (or a year and a day later), you sort the DJIA by dividend yield and replace stocks no longer in the top 10 with stocks that now appear in the top 10. Again, you buy (or rebalance) in equal dollar amounts.

Historical Performance

For the years 1973 through 1991, the strategy yielded a total return of 1753% (according to O’Higgins).  That is an annual compound return of 16.6% versus the DJIA’s annual total compound return of 10.4% during the same period.

O’Higgins also identified a more volatile, more profitable variation (now referred to as the Little Dogs or Small Dogs of the Dow).  From the highest 10 yield stocks, you buy equal amounts of the five with the lowest cost per share. The annual compound return?  For the test period, it was 19.4%.

James O’Shaughnessy (Predicting The Markets of Tomorrow) likens the Dogs of the Dow to the Fama/French Large Value Index.  From 12/31/1928 through 12/31/2004, the real average annual return was 8.63 percent compared to the Fama/French Index real average annual return of 8.24 percent.  The S&P real average return during this period was 6.29 percent.

O’Shaughnessy also points out that the Dogs of the Dow had a smaller standard deviation than the Fama/French Large Value Index.  He suggests it can be the large cap value component of a stock portfolio.

In What Works on Wall Street, O’Shaughnessy determined that the compounded annual total return from 1963 to 2003 was 13.9%.  Not as good as the results of the more limited data used by O’Higgins.

What is the basis of the strategy?

The basis of this investing strategy is the dividend yield valuation model. Every company has occasional down periods where their stock price drops.  As long as they do not lower their dividend, their yield will increase. In this case, high yield is a simple way to identify the beaten down Dow companies.

Because the strategy applies to the bluest of the blue chip stocks, the Dow Industrials, additional criteria are ignored. The rationale is that these are the very best companies and do not require extensive analysis to determine if they will recover.  However, being a component of the DJIA guarantees neither longevity nor success.

Since this is mechanical investing, proponents suggest no further analysis once the screening is complete. On the other hand, it is prudent to confirm the dividend is expected to continue. Check out the companies passing the screen to see if bad news is in the making.

For example, Citicorp was one of the selections in January 2008. Checking the news, it became apparent that a dividend cut was a real possibility. The cut did occur. It remains to be seen if Citicorp will be one of the winners of the January 2008 Dogs.

The dark side of the Dogs of the Dow

Dividends are a traditional way for companies to create value for shareholders.  But growth companies are expected to create value for shareholders by growing, not by paying dividends.  The Dow Jones Industrial Average contains both types of companies.

As a result, if only dividend yield is considered, some components will never be selected as Dogs.  For example, for Hewlett-Packard (HPQ) ever to be included in the list as a high yield stock it would probably need to be trading at 20% of its historical pricing.  Maybe it would be a good buy at that point, but has it ever made the list? 

General Motors (GM) recently suspended its dividend.  It cannot make the list until it resumes paying a dividend.

These examples illustrate that not all components of the DJIA will actually be candidates for selection.

Diversification using the Dogs of the Dow

A diversified investment portfolio normally includes a large cap value component. If you want such a component, O’Shaughnessy (as noted above) thinks this is an option.

One of the reasons for choosing the Dogs as the large cap value component of a portfolio is the small number of stocks required to satisfy the strategy.  Most large cap value strategies recommend 20 or more stocks to achieve the same level of volatility.

Keep in mind that from a performance point of view, there may be better universes of stocks than the Dow Industrials.  ValueLine, Morningstar and S&P highly rated stocks would be examples.

Also consider a starting date other than January 1.

Variations

Jack Hough in his recent book, Your Next Great Stock, points out that dividends are only one way a company can increase shareholder value.  Another is share buybacks.  He cites a study supporting this and suggests an alternative approach (the New Dogs) using both dividends and share buybacks. He refers to this as Net Payout Yield.

James O’Shaughnessy cites the same academic study but refers to the evaluation of dividends and share buybacks as shareholder yield.

Same concept - different name.

The Motley Fool created a 4 stock variation of the Dogs (the Foolish 4) using the Small Dogs as a starting point. Note, however, that the Fool no longer considers this a valid investing strategy.

Its simple and it works, what isn’t there to like?

Well, depending on who you ask, quite a bit.

There are several common criticisms of the strategy.  One is that only US companies are included in the DJIA.  Therefore, you would miss growth in emerging markets.  This is not really a valid criticism since the companies included in the average are multi-national companies.  And recovery, not growth is the feature of the strategy.

A second criticism is that although these are stable companies, likely to recover, the universe of stocks is limited to the 30 components of the DJIA.  A simple solution (if you agree with this criticism) is to screen a broader universe of large cap stocks using a yield strategy.

Perhaps the most damning criticism is that so many people use the strategy it is a victim of its popularity. This is more commonly a problem when popular stock screens pick less liquid stocks than DJIA components.

For example, when trading the AAII Zweig screen several years ago, I noticed what seemed like disproportionate activity in companies passing the screen the day following the availability of the data.  The Dogs have huge average trading volumes but may be susceptible to this phenomenon if enough mutual funds participate in the strategy.

Screening for Dogs of the Dow (and small dogs and new dogs)

There are several online stock screeners with predefined screens for the Dogs of the Dow (Big, Small and New).  It only makes sense to create a custom screen in a fee-based screener if you already have access to the screening software and didn’t feel like going online.

Free stock screeners with Dogs of the Dow screens:

For the Dogs, the best stock screener is a free stock screener. These free stock screeners offer predefined screens for the Dogs of the Dow.

Although SmartMoney is a fee-based screener, it has a predefined free stock screen for the New Dogs using both share buybacks and dividends as part of the yield calculation (Net Payout Yield). If Net Payout Yield makes sense to you, SmartMoney offers the only free screen (that we have found) with this feature.

MSN Money’s Stock Power Searches has a predefined screen for the Dogs (see under the fundamental screens column) using dividend yield.

Yahoo! Finance offers a preset screen for the Dogs of the Dow . It allows you to change the parameters (minimum yield or DJIA) if you choose to do something a little different. For example, you could change from the DJIA to the S&P 500. Remember, though, there is no published historical performance for anything but the DJIA dogs.

The following free stock screeners do NOT have a Dogs screen.

AOL Finance has no Dogs screen and cannot identify DJIA components. It is possible to build a large cap high yield screen.

CNBC does not offer a predefined screen for the Dogs of the Dow but does offer one for the S&P 500 . Keep in mind that there is no published historical performance for the Dogs of the S&P.

Google Finance has no Dogs screen and cannot identify DJIA components. It is possible to build a large cap high yield screen.

Morningstar (free) does not have a predefined screen for the Dogs, but they do offer the variation for high yield large cap stocks . To get to that screen, use the above link and select the Morningstar Screen for High Dividend Yields (list is on the left of the screen). Once again, the published performance of the Dogs will not apply.

Build and backtest your own Dogs screen

Now that StockScreen123 offers backtesting in their free screener, it is possible to implement your own Dogs of the Dow strategy and examine recent performance. We have documented the implementation and backtesting process.

Can’t get enough of the Dogs?

If not, there is an entire site devoted to the Dogs . It has an interesting remark by O’Higgins on his current thinking in this area.

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