Will the Dogs of the Dow Beat the Market Again in 2014?

Will the Dogs of the Dow Beat the Market Again in 2014?

Keen investment strategy or alliterative parlor trick? That was the main question on my mind as I was catching up on how the "Dogs of the Dow" equity strategy has fared over the past few years. For those unfamiliar, Dogs of the Dow is a rather simple method of portfolio construction: On the first day of the year, buy the 10 stocks in the DJIA that have the highest yields. Hold for the entire year, then just rinse and repeat. So every 12 months you'll have a new portfolio (although some of the individual stocks may still be in that top 10 the following year).

Simple enough in theory, but there's been some debate recently about whether the strategy is actually outperforming [3] the market - or not [4], even as recently as last year. Without getting into all the asterisks and "well, but..." situations on either side, suffice to say that the Dogs of the Dow has either slightly outperformed or slightly underperformed the S&P 500 over the past 5 years - not a ringing endorsement by any means, but it doesn't mean that today's market environment isn't well-suited to owning high quality dividend stocks.

Weighing the "Bull"-Dog Case

Proponents of the Dogs of the Dow theory point to three main attributes:

1) Blue-chip stocks: by limiting the universe to the 30 Dow Jones Industrial Average stocks, you're assuring yourself of investing in large companies with long operating histories and powerful brands. That doesn't guarantee no duds, but it certainly ups the odds a little.

2) Dividends : most DJIA stocks have solid dividend yields, and choosing the 10 highest each year pretty much assures you of having a portfolio with an above-market yield.

3) Out-of-favor stocks : The idea is that these 10 stocks have such high yields because the stock prices have fallen in the past year, so they may be temporarily out of favor and due to "revert to the mean". This is predicated on #1 being true, i.e. that these companies are entrenched, long-term success stories.

2014's Dogs of the Dow

I created a portfolio in Capital Cube of the 2014 members so that I could look at the aggregated metrics of the group and compare them to a default broad market holding like the SPDR S&P 500 ETF (NYSE Arca: SPY [5])

Dogs Of the Dow 2014 Portfolio Analysis from CapitalCube [6]

Dogs of the Dow 2014 Valuation Metrics from CapitalCube [7]

The portfolio's P/E of just over 16x trailing is lower than the broad market, but not by very much. And since the Dogs strategy is essentially one of value investing, that's one point against the 2014 list. But balancing that out is a very solid number for the aggregate dividend payout (54%) and an attractive Price/EBITDA multiple of less than 8.5 times.

All in all, it's a good-looking list to me; all 10 of these are stocks I can justify holding for both the short-term and long-term. I've given positive coverage this year to over half the list, often in terms of their attractiveness as fixed income proxies [8] and long-term dividend growers [9]. What I don't like about the Dogs of the Dow strategy is the blind acceptance of turning potentially the whole portfolio over year after year, which leads to higher frictional costs (commissions, fees, and taxes). If I happen to especially like the 12-month prospects for Merck (NYSE: MRK [10]) and Verizon (NYSE: VZ [11]) - which I do - why should I have to sell it if the dividend yield happens to drop to #11 in the Dow next year?

My Final Take - ALPS Sector Dividend Dogs ETF (NYSE Arca:SDOG [12])

A stock investing strategy that requires some asterisks just to say it's beaten the market about half the time doesn't jump out as anything special. Monkeys throwing darts can beat the market half the time. Having said that, I think this particular year's 10 "Dogs" look pretty good, and I'd bet that they will outperform the S&P 500 through year's end. But that doesn't mean I'd want to blindly roll the strategy over next year, and that doesn't mean it's a diversified group (notice there is NO financial exposure).

If you happen to be keen on the overall philosophy of finding (potentially) out-of-favor stocks and (definitely) above-market yields, I'd recommend the ALPS Sector Dividend Dogs ETF (NYSE Arca: SDOG). First and foremost, it's more diversified than the standard Dogs approach, as SDOG holds 50 stocks [13]. Here is the sector asset allocation for the ETF:

ALPS Sector Dividend Dogs ETF (NYSE Arca-SDOG) Sector Asset Allocation from CapitalCube [14]

It applies the same approach of finding the highest yields, only it goes by sector, plucking out the highest-yielding names within each sector of the S&P 500. Because of this, SDOG currently yields over 3%, or 50 basis points more than both the 10-year Treasury and the S&P 500.

SDOG) Performance vs. Peers from CapitalCube [15]

While SDOG's 7.7% return is outperforming some key peers in 2014, the fund is only two years old, so there's no long-term performance history for investors to lean on. It's also got a 0.4% expense ratio, which is not obscene but definitely higher than the median for largecap stock ETFs.

Companies are generating, earning, and distributing record amounts of cash. There are fantastic stocks and above-market yields to be found all through the S&P 500, not just at the very tippy-top of market caps. Decide your sector exposure first, then go hunting for great values, or just go pick up SDOG for a quick bite of the dividend bone.

The views and opinions expressed above are those of the author and do not necessarily reflect the views of CapitalCube.com, AnalytixInsight, Inc., its affiliates, or its employees.

Disclaimer [16]