Dogs of the Dow | Dogs of the Sensex

Dogs of the Dow or the Dow 10 strategy has been regarded as one of the most successful investment strategies of all time. The strategy first found mention in "Study of Industrial Averages Finds Stocks with High Dividends are Big Winners," Wall Street Journal, August 11 1988,p.C2 by John R. Dorfmann. However the credit for popularising the strategy belongs to Michael O'Higgins and John Downes for their 1992 book Beating the Dow. Around the same time Harvey Knowles and Damon Petty also emphasised the strategy in their book The Dividend Investor.

Why is the strategy called Dogs of the Dow? The strategy calls for investing in the 10 highest dividend yield stocks from the 30 Dow Jones Industrial Average (DJIA) stocks.Dividend Yield is a value measure where you divide the latest annual dividends by the current stock price. So a high dividend yield usually implies stocks whose prices have fallen and are thus out of favour with investors. Thus was coined "Dogs of the Dow"!

The strategy requires investing an equal amount in the top 10 dividend yield stocks and rebalancing the portfolio every year weeding out those that fail the criteria and supplementing the rest with new stocks that qualify.

How consistent has been the performance?

The reason that Dogs of the Dow strategy is so popular has been its remarkable consistency in performance. Jeremy Siegel in his very insightful book Stocks for the Long Run has shown the compounded annual returns from investing in the Dow 10, as opposed to the 30 stock DJIA and the S&P 500 Index, as reproduced in the following table. From 1928 to 2001 compounded annual returns from the Dow 10 of 12.9 percent beat the DJIA by 1.5 percent annually and the S&P 500 Index by 2.19 percent per year. Numbers in parenthesis, depict the standard deviation of annual returns.

The Dogs of the Dow strategy outperformed Dow 30 and the S&P 500 index in every decade except 1930's and 1990's. It failed to outperform these in 1990's because of 1999, the year of the dot-com mania, and the single worst year for the strategy underperforming the S&P 500 Index by a whopping 18.34 percent.

According to Professor Siegel's study, since the 1930's the Dogs of the Dow strategy has outperformed the 30 stock DJIA in 43 of 62 years. And in 11 of the 19 years that the Dogs of the Dow strategy failed to meeet the 30 stock DJIA, it did so by less than 2 percentage points. In only 4 years it underperformed the 30 stock DJIA index by more than 5 percentage points. The worst performance was as mentioned before in 1999, when technology stocks defied gravity and value stocks completely fell out of favour. Contrast this with the fact that in 9 out of the 43 years (that the Dogs of the Dow strategy outperformed the Dow 30 DJIA), it outperformed the Dow 30 by more than 10 percentage points.

Spectacular returns -achieved with higher risk?

One might have thought that such spectacular returns must have been achieved with higher average risks. Again Professor Siegel shows us that this is not the case. As can be seen from the table above, the standard deviation (in parenthesis) of the annual returns on the Dow 10 strategy actually was lower than that of the Dow 30 and slightly higher than the S&P 500 index. And the Dogs of the Dow strategy performed spectacularly in bear markets of 1973-74. During these 2 years the Dow 30 was down by 26.5 percent and S&P 500 Index was down by 37.3 percent, but the Dogs of the Dow strategy had actually gained 2.9 percent!

Why does it work for the Dow Industrials? Should it not work outside the DJIA too?

The strategy works for the Dow Industrials because these stocks are a group of superior survivor firms. These are large, well-known companies with immense financial resources and solid long-term track records that have weathered many economic storms. Their size and history provide these companies with a resilience that makes them relatively conservative investments that are unlikely to enter financial distress. The Dow Jones industrial average is actually a diverse group of companies, competing in a wide range of industries from industrials, oil and gas, financial services, retail, technology and communication stocks, and even entertainment and food firms.

On the other hand, the market tends to overreact to unfavorable short-term developments and business cycles, and drives prices down to bargain levels. Large institutional investors who dominate market trading and can thus cause sharp volatility are also largely to blame. For individual investors, according to O'Higgins and Downes, this creates more opportunities than disadvantages, because they have greater flexibility to focus on the limited number of stocks in the approach.They further argue that the Dow stocks are so visible and widely analyzed that it is rare that surprises with major adverse financial implications occur.

Will the Dogs of the Dow strategy work as well in the future?

Professor Siegel and many others have argued that it MAY NOT -Whenever a strategy gets well publicised, it often does not work. Professor Siegel's data shows the Dow 10 strategy reached its peak in 1996 after working 6 years in a row. Since then, in the past 13 years the performance has been patchy. The strategy fell slightly behind in 1997 and 1998, before being crushed in 1999 when growth stocks reached stratospheric heights. But again, as can be seen from the table below, it beat the S&P 500 Index and the DJIA handily in 2000, 2001 and 2002, (as it did in the bear markets of 1973-74). While in 2006 the strategy again delivered handsomely, it fared poorly in 2007 and 2008 underperforming the DJIA by huge margins.

Check out ValuePickr's Dogs of the Sensex stock screen selections for the Indian stock market, here.

The Dogs of the Dow is a value approach. It hasn't worked in markets driven primarily by growth stories. There does seem to be a strong correlation of outperformance in bear markets, though. Logically this seems understandable due to the propensity of capital tending to get relocated to safer pastures first - the strongest stocks - during bear markets.

Other criticisms, if any?

None of the studies mentioned actually account for transaction costs (of rebalancing every year) and taxation costs (incurred on gains). Its possible that much of the sheen of the excess returns would be eaten away by these additional costs.

How do I pick my own dogs?

Simple. The Dogs of the Dow website maintains a current list of Dogs of the Dow based on last Friday's closing prices. This is a completely free site and as you might have guessed, a comprehensive storehouse of information on the strategy. Or you can do it the hard way by collating the annual dividends of the DOW-30 stocks, calculating the dividend yields, and then ranking them by highest dividend yields and selecting the top 10.

Implications for the Indian Stock Market

The Dow-10 or Dogs of the Dow strategy could well work for the BSE Sensex-10 or NSE Nifty-10 highest dividend yield strategy. The BSE Sensex and the NSE Nifty Index comprise of superior survivor firms with strong long term records having weathered many economic cycles, a diverse group from a wide range of industries. Would be good to find a source of historical performance data for these though, isn't it?

In India currently we will have the additional advantage of avoiding taxation costs by rebalancing the portfolio once every 366 days since long term capital gains (> 1 year investment gains) are completely tax-free.