A Look at the Dogs of the Dow Strategy

The Dogs of the Dow is an investing strategy popularized by Michael B. O’Higgins in his 1991 book Beating the Dow. It uses a dead-simple methodology to invest in blue chip stocks that provide a solid dividend return with reduced volatility. This is how it works:

1. At the end of the year, identify the 10 stocks of the 30 Dow Jones Industrial Average (DJIA) stocks that have the highest dividend yield.
2. Invest equally in all 10 on the first day of the year.
3. Hold these stocks for a year.
4. Rinse, repeat.

It doesn’t get much simpler than that. Despite our dog-friendly company name, we at Stock Rover are naturally skeptical of this strategy—or at least dogmatic (sorry!) adherence to it. Its rigid and absolute rules remove all agency from the individual investor, and our company goal is to provide more agency to the investor. And if you’re reading this article, chances are you are the type of investor who has at least some appetite for stock picking.

So let’s dig in to see if we can figure out what this strategy is really doing and offer some possible updates to it.

Strategy Premise

First, let’s examine the premise of the strategy. The Dogs of the Dow is often referred to as a contrarian or value strategy because it uses the price-based metric of dividend yield. High dividend yield can be an indication of poor price performance, so screening on dividend yield can help lead to stocks that have depressed prices (hence “dogs”). However, high dividend yield can also result from a high expected dividend payout, regardless of stock price. So, a low-priced stock with an average dividend per share could have the same yield as an average-priced stock with a high dividend per share. Without context, dividend yield does not tell you much about valuation, performance, or dividend strength—or about the fundamental investability of a company at all.

That is why the Dogs strategy uses the Dow Jones Industrial Average (DJIA or “the Dow”) as context. In this curated group of blue chips, a stock’s fundamental qualifications and safety as an investment are considered implicit, so a high dividend yield supposedly will lead you to solid investments at a good value. This is the premise of the Dogs of the Dow, and it’s quite elegant, when you think about it. But it’s also so simple that it may be just simplistic, and, as I will explain, it may not truly be a value or contrarian strategy.

To set the scene, I’ve created a simple Dogs of the Dow screener (available in the Library) that finds the current Dogs, i.e. the 10 highest yielders in the Dow currently. Here they are:

The table includes a number of columns we will use for comparison later.

Valuation of the Dogs

Here are the 30 DJIA stocks, sorted by Forward P/E and showing dividend yield. The current Dogs (those from the above table) are called out in red:

Forward P/E is appropriate to use here because, like dividend yield, it is a forward-looking metric. Forward P/E compares the current price to estimated earnings for the next fiscal year and dividend yield compares the forecasted 12-month dividend payout to the current price. If Dogs of the Dow were truly a value strategy, we would expect to see a correlation between a low forward P/E and a high dividend yield. But we aren’t seeing a particularly compelling correlation. 5 of the Dogs are among the top 10 least expensive by forward P/E, with a 6th just outside of the top 10, but the remaining 4 are at the other end of the spectrum. And the cheapest company, Goldman Sachs, also has a lower-than-average dividend yield.

To slice it another way, the average forward P/E of the current Dogs is 14.7, while the average for the entire DJIA is 15.0—not a huge difference. The current P/Es, not shown in the table, are also very close: 19.3 for the Dogs, 19.6 for the DJIA. You might also have noticed in the earlier table that about half of the Dogs were trading at or close to 5-year historical P/E highs—in other words, they are at historically high valuation points, not low ones.

All in all, some value may be achieved with the Dogs relative to the index, but not much, at least not if forward, current, or historical P/E are your measurements for valuation.

Performance of the Dogs

This strategy is also billed as contrarian for the same reason it is billed as value: a high dividend yield could indicate poor price performance and therefore out-of-favor stocks. Let’s look at that. Here is the Dow sorted by 1-year price performance, with the worst performers at the top, and the current Dogs called out in red:

Once again, the worst performers aren’t especially high yielders—in fact the 3 worst performers all have a below-average dividend yield, and the top 10 most out of favor contain only 4 Dogs.

On the other hand, the average 1-year return of the current Dogs is -0.5%, compared with the DJIA average of 2.1%. So the strategy is finding stocks that tend to be out of favor, just not the worst performers.

I also compared return over shorter periods and the results were similarly mixed. Several of the Dogs had above average returns for those periods, while others had middling or below average. When averaged, the current Dogs actually outperformed the DJIA in the 1-, 3-, and 6-month periods.

These tests lead me to conclude that high dividend yield, at least within this controlled population, does not necessarily lead to contrarian picks.

Income of the Dogs

So if the strategy isn’t picking stocks that are definitely inexpensive or definitely out of favor, what exactly is it doing? It would seem, by virtue of its organizing metric, to be an income strategy. Naturally, a high dividend yield-based strategy aims to get you the most dividend bang for your buck. And it appears to do just that.

In 2015, the annualized yield for the Dogs portfolios was 3.8%. For comparison, I created a rough-cut DJIA portfolio (all current Dow stocks purchased equally at the beginning of 2015), which had an annualized yield of 2.8% in 2015, a full percentage point behind the Dogs of that year. That is just a back-of-the-napkin sample, but it at least supports the intuitive conclusion that the Dogs would bring home more bacon in a year than the Dow average.

What about total return? The dividend-adjusted return of a Dogs portfolio has been shown to beat the DJIA in most years, although Forbes contributor John Tobey argues that because the equal-weighted structure of a Dogs portfolio mismatches the price-weighted DJIA, the comparison isn’t accurate. My own analysis of the 2014 and 2015 Dogs has them outperforming the (price-weighted) DJIA, but those margins of difference appear to be much narrower or non-existent against an equal-weighted version of the DJIA. However, when factoring in risk, the Dogs may have an edge against the whole DJIA, or at least in 2015 they did. The risk-adjusted return versus the S&P 500 of the Dogs in 2015 was 3.2%, compared with the 2.6% risk-adjusted return of the DJIA portfolio.

Possible Modifications to the Dogs of the Dow

The above exercises lead us to believe that the tack of using highest dividend yield in the DJIA context is not without merit. It can help find somewhat out-of-favor, somewhat inexpensive stocks (although not the most out-of-favor or most inexpensive) that provide above-average income during the holding period and mayprovide a slight performance edge over the Dow with lower risk. And it does all this with an extreme minimum of effort.

But does that sound like a sufficiently compelling strategy, one to which you want to submit capital?

Not really. O’Higgins’ book presumably holds further secrets about how to use this strategy and others to maximum effect, but as it is presented online, the Dogs of the Dow is concerningly blunt. And we haven’t even spoken of 10 stock mandate or the prescription to refresh your holdings only at the beginning of each calendar year—those are easy to remember but completely arbitrary as far as performance goes. In fact, the once-yearly trading schedule could be detrimental from a tax perspective if you are selling any stock at a gain exactly one year after buying it—in such cases, the short term capital gains tax rate applies.

Let’s explore some possible modifications to the Dogs of the Dow in each of its dimensions that might give it a little more tooth for whatever your investing goals may be.

Screening Population

We like using the highly curated context of the Dow 30 as a shortcut to finding blue chips. The downside is, of course, opportunity cost—there are far more than 30 companies worthy of consideration in the market. But if simplicity is paramount, stick with the Dow. Alternatively, a simple but safe modification would be to expand the screening population to the S&P 100. Or, you can create screeners or use our pre-existing screeners to find large, low-beta, slow-growing, dividend-paying companies (for example, see the screenerLarge, Low Risk Dividend Payers in the Library). A few examples of companies that are not in the Dow but have a Dow-like profile are: MasterCard, Comcast, Starbucks, Lowes, CVS, and Honeywell.

Value

If it is really value that you are after, consider sorting on forward P/E to find the companies that have the lowest price compared with next year’s expected earnings. Or, use 5-year P/E range to find stocks with the lowest P/E relative to their own history, meaning that even if the P/E isn’t low in an absolute sense, it may be a good time to buy the company given its valuation history.

You can combine value with dividends by creating a simple filter on dividend yield to ensure that you are still achieving an above-average dividend yield.

Here is a screener that ranks on a combination of forward P/E and 5-year P/E range, and filters on dividend yield (2.8% is the average dividend yield of the DJIA at the time of writing):

These are the top 10 ranked stocks that result:

The first half of the list contains all current Dogs, but the second half differs. The yield is 40 basis points below the yield of the Dogs screener and the forward P/E at 14.0 is only slightly less than the Dogs average of 14.7, however the historical valuation is relatively favorable (none of these stocks are at their historical highs) and the beta 1-year is lower. Removing the dividend yield filter results in a significantly lower average forward P/E of 11.3.

Out of Favor

If you consider yourself more of a contrarian than a value seeker per se, then you could focus on performance and momentum rather than dividend yield or earnings. Looking for lowest return over a given period or the lowest money flow index (MFI) (a volume-weighted version of the relative strength index) can help find the companies in the Dow that are out of favor or currently oversold. This essentially amounts to a revert-to-mean approach where you buy solid companies that have had poor recent performance, on the expectation that they will bounce back.

Note that, without the sound fundamental setting the DJIA provides, we would never advise trading on technicals alone for long-term picks. Even within the DJIA, you might want to incorporate additional filters to ensure that the results also meets a fundamental baseline of yours.

Here is a Dogs screener modified to find stocks that have been recently out of favor:

And the results…

This list shares 4 tickers with the current Dogs. Despite the screener criteria, the average 3-month return is pretty good, 4.4%, but that is still less than half that of the current Dogs (9.6%) and less than the whole DJIA (7.4%). None of the tickers are severely oversold according to the MFI (far right column), but they tend to be more oversold than the rest of the DJIA. Opening up this screener to a larger population such as the S&P 100 would result in a more out-of-favor list. You could also modify the return period, the weight distribution, or the metrics to calibrate this screener more specifically to the type of out of favor stocks you want to see.

Income

If dividend income is your objective, the current Dogs of the Dow approach may not be far from what you need. We can’t help but sneak some dividend growth and dividend safety into the mix however. Filtering on dividend yield alone with no consideration of payout ratio, free cash flow, or dividend growth over time means that you could be attaching yourself to a yield that is not sustainable. The Dow is generally a safe zone as far as dividends go, but even its companies are not immune to occasional dividend downgrades. Furthermore, a growing dividend can mean that the company is generally strong, which could lead to a higher stock price and therefore higher total return. Below is an option for an income and dividend growth-oriented Dow screener.

These weights could be easily shifted around according to what you most care about in a dividend payer. Note that the free cash flow payout ratio is a more targeted version of the payout ratio that shows how much of free cash flow is being used for dividends. If the number is low, it means there could be more room to grow the dividend. Here are the screener’s resulting 10:

This list only has 3 in common with the current Dogs. Here, the dividend yield of 2.4% is much lower than the Dogs and even below the DJIA average. Interestingly, the forward P/E is the lowest so far, with the valuation compared with historical valuation also looking pretty favorable. The beta 1-year is a bit higher (although not high, by any means). The average dividend growth, as expected, is significantly higher than in the other screeners.

Number

Although like the original Dogs of the Dow we’ve used 10 as a cap in the above screeners, we see no reason you need to select exactly 10 stocks. Use your own judgment about how many stocks to include based on the amount of capital you are investing and your feelings about the stocks involved. If you are using ranked screeners, you can modify the number of passing stocks so that you only see exactly the number you plan to invest in. Or, you could allow more to pass and then use your own subjective assessment to eliminate a few from the final portfolio.

Allocation

The equal allocation approach used by the Dogs of the Dow need not be changed. Not only is it easy to remember, but it’s a great way to naturally diversify your portfolio and protect against risk. However, you may want to avoid weighting more than 30 or 35% in any given sector.

Timeline

If nothing else, we suggest ditching the calendar year cycle proposed by the Dogs of the Dow. Even the slightest level of attention to technicals, historical valuation, macro trends, and seasonal cycles can help you locate better entry and exit points than using fixed calendar-based dates.

Additionally, to avoid the short-term capital gains tax, sell any stocks at a gain only after more than a full year has elapsed. Selling stocks at a loss can occur anytime with no penalty; although you can be strategic with losses as well, taking them at the same time as gains in order to mitigate the overall tax burden.

Summary

The Dogs of the Dow presents a maximally simple approach to investing that may be somewhat effective in finding inexpensive and safe income stocks. However, its inflexible approach to stock picking removes investor agency and forfeits potentially better investment opportunities. And while the DJIA context provides a relatively safe playing field, the sole stock picking mechanism—dividend yield—appears to be an overly simple stand-in for other metrics that could help you more effectively target value, out-of-favor, or income picks.