Saturday, December 24, 2016

Tracking The Dogs Of The Dow

I’m quite surprised that I’ve never mentioned the Dogs of the Dow here given that it is probably the single best known investing strategy around. Basically it works as a kind of value screen whereby you take the top ten stocks in the Dow Jones Industrial Average ranked by dividend yield (highest yield first) and rebalance them. That’s essentially it. Every year you eliminate those stocks from your portfolio that are no longer in the top ten and promote those that are.

The concept behind the strategy is that from time to time certain stocks within the index will fall out of favour with investors for various reasons. It could be as a response to a black swan kind of event that hits a company’s stock price hard over a short length of time, or it could be that you enter a downward leg in the business cycle which affects underlying earnings. Either way the point is that the high dividend yield tends to reflect cheaper value, and cheaper value in turn signals higher forward returns.

It’s exactly the same effect that made Royal Dutch Shell the only oil stock to make the list of twenty top performing original S&P 500 members (although most of the oil majors have delivered great long-term returns). Same deal with the returns of the tobacco stocks, and in particular Philip Morris – the single best performing original S&P 500 stock. The only difference with the Dogs of the Dow is that it’s been converted into a kind of automated strategy – limited to an index of thirty of the stodgiest of stodgy blue chip stocks.

Let’s take a look at the performance of the screen since the turn of the century. This gives us a couple of market cycles to look at – namely the dot-com crash and global financial crisis of 2007-2009 – which makes it a pretty decent time-frame for gauging long-term returns. Imagine you open a separate brokerage account just for the purposes of investing in the Dogs of the Dow stocks. At the start of the first calendar year you deposit $100,000 and place automated buy orders for the ten highest yielding shares in the Dow Jones Industrial Average in equal amounts.
  • Doing so would have seen you pick up $10,000 blocks in Philip Morris, J.P. Morgan, General Motors, Caterpillar, Eastman Kodak, Exxon Mobil, 3M Company, AT&T, DuPont and International Paper.
Your average dividend yield for this miniature blue chip portfolio would have been 3% on day one. Just check out some of the names that you were investing in at the beginning of the first year though. Eastman Kodak for example would’ve gone bankrupt in 2012. Chemical company DuPont has seen its stock price go virtually nowhere between the late 1990s and the present day. Iconic American car manufacturer General Motors would also end up in bankruptcy during the turmoil of the global financial crisis. Indeed ordinarily you’d probably never consider long-term investments in the auto manufacturers because they’re so cyclical and actually pretty unprofitable.

The point is though that the Dogs of the Dow is not a buy-and-hold strategy. It’s more like a value index fund. Indeed if you were to go back a little bit further you’d find that between 1997 and 1998 around 25% of your portfolio would’ve been in the various oil majors – Exxon, Chevron and Texaco – which were on discount due to the oil price slump of the late 1990s. When the oil price was booming in 2005-2006, along with stock prices of the oil majors, none of them would’ve made the list.

Let’s say you manage to stick to the strategy perfectly. At the start of each year you pull up a list of the Dow 30 stocks and rank them in order of dividend yield. Those stocks in your portfolio which no longer make the top ten are sold on the first trading day of the year regardless of whether they are currently in profit or loss. At the same time any new entrants into the top ten are purchased in the usual $10,000 blocks. In addition all dividends received must be reinvested back into the portfolio.

Had you done that then the $100,000 starting capital would currently be worth about $320,000. On an annualised basis that comes to average compounded returns of 7.2% per year. In comparison an investment in the benchmark Dow Jones Industrial Average would have generated average compounded returns of 5.2% per-year. Over a sixteen and a half year stretch that extra 2% per-year adds up to around $87,500 in additional returns assuming starting capital of $100,000.
The key is that you maintain the discipline to stick to these strategies over long time frames; something that is easier said than done in practice. During those sixteen years there were stretches such as 2006 to 2009 in which the strategy would’ve underperformed relative to the benchmark.
Let’s take a look over a longer time period. After all only going back to 2000 probably isn’t enough to draw any reasonable conclusions. According to data provided by Jeremy Siegel in his book – Stocks For The Long Run – the Dow 10 strategy as he calls it generated geometric returns of 12.6% per-year between 1957 and 2012. In comparison the Dow Jones Industrial Average delivered 10.9% compounded per year over the same time frame. That 1.7% difference looks small when expressed as an annual figure, but compounded over a fifty-five year time frame it adds up to an absolutely huge $387,000 on an initial total investment of just $1,000.

The interesting thing about Siegel’s study is that he also compared the S&P 500 stocks on a similar basis. The S&P 10 as he calls them – those being the ten highest yielding stocks from the largest one hundred companies in the S&P 500 universe – generated compounded returns of 14.1% a year between 1957 and 2012. In comparison the benchmark S&P 500 delivered annualised geometric returns of 10.1% over the same period.

The usual caveat applies here in that there’s no guarantee that future returns will match the historical performance. What it does show though is that even the most basic value strategies have the potential to deliver great returns if you’re prepared to stick to them, whilst at the same time perhaps taking some of the emotion out of traditional buy-and-hold strategies.

Finally for those who are interested I’ve attached a list of the current Dogs of the Dow and their respective dividend yields:
The Dogs Of The Dow 2016