Stocks Notch Another Winning Year

The bull market remained alive and well in 2014, marking a sixth-straight year of positive returns for equities. Although the Dow Jones Industrial Average and the S&P 500 Index did not match the pyrotechnic performances of 2013 (up 26.5% and 29.6%, respectively), they still made for interesting watching, thanks to the multiple times they achieved new highs throughout the year. Meanwhile, the NASDAQ Composite Index returned to levels not seen in over a decade. Altogether, the indexes in 2014 ranked in the same order as the previous year. The NASDAQ led once again, climbing 13%, the S&P advanced by 11%, and the Dow was up 7.5%.

A Close Race To The End, But The Dogs Bow Out In December

The Dogs of the Dow put in a good showing in 2014. Indeed, they were the year-to-date leaders in all but two months (February and October). And, even as late as November, were 40 basis points ahead.

But, it all seemed to fall apart in December. So much so that seven of the 10 stocks lost ground, two were flat, and only one issue advanced. By comparison, more than half of the other 20 Dow components posted gains for the month. When all the dust had finally settled, the Dogs clocked in with a 2.9% decline for the final month. This compared to a dip of 0.8% for the 30 Dow stocks as a whole, and a 0.3% uptick for the 20 “nondogs”.

While there was more than enough blame to spread around, four names made outsized contributions to the underperformance; Verizon (VZ Free Verizon Stock Report), which was down 7.5%; Merck (MRK - Free Merck Stock Report), was down 6%; AT&T (T - Free AT&T Stock Report), fell 5.1%; and finally, General Electric (GE - Free GE Stock Report), which slipped 4.6%.

The mutts also got trounced for the quarter, shedding 0.2%, versus a 3.9% gain for the Dow as a whole, and a 5.9% advance for the nondogs. Notably, six out of the 20 stocks included in the latter group made double-digit gains in the period, while none of the Dogs crossed that threshold.

The Final Tally

All told, the Dogs were up 7% for the full year, which, by historical standards, is in line with the long-term average return for stocks. However, an equal position in all 30 Dow Stocks would have put you ahead by 9.1%, while putting all your money on the 20 Dow components excluded from the Dogs would have resulted in a 10.1% gain.

(Note: An equally weighted position in each of the Dow companies would have returned a higher percentage (9.1%) versus the actual Dow Jones Industrial Average itself, which was up 7.5%. This mismatch is due to the fact that the Index is price weighted, meaning that higher-priced issues have a greater impact on its calculation. In last year’s case, that weighting worked against the Index.)

The Year’s Big Winners

Chip maker, Intel (INTC - Free Intel Stock Report) not only topped the Dogs, but also beat out all other Dow stocks with its 39.8% gain. Microsoft (MSFT - Free Microsoft Stock Report) also put in a good turn, with the software giant’s shares rising 24.2%. Cisco Systems (CSCO Free Cisco Stock Report) also did well, advancing 23.2% on the year. Indeed, this trio did so well that they were kicked out of the Dogs. Specifically, largely because of their solid price gains last year, their dividend yields no longer rank among the 10-highest of the Dow Industrials, which is the key selection criteria for this strategy.

Bringing up the rear were, Chevron (CVX - Free Chevron Stock Report), down 10.2% and General Electric (-9.8%). Also finishing in the red were the two telecoms, AT&T and Verizon (down 4.5% and 4.8%, respectively), and McDonald’s (MCD - Free McDonald’s Stock Report), which declined 3.4%.

New Dogs For Old

As a brief summary to bring new readers up to speed, the Dogs of the Dow strategy basically calls for investing equal dollar amounts in the 10 highest-yielding components of the Dow Jones Industrial Average. Then, 12 months later, the process is repeated. (While this system can be initiated at any time, many followers choose the start of the calendar year for ease and comparative purposes.) The basic premise behind the system is that some of the stocks make the list because they have fallen out of favor with investors. And, being as these are long-established, conservative, well-capitalized companies with dominant positions in their respective industries, the situation is likely to be a temporary one. In that sense, the system has a modest contrarian component. The strategy also appeals to income investors, due to the emphasis on yield. Another draw is the fact that the system requires little monitoring and normally results in very few trades (and those being only once a year), thus saving on brokerage fees.

With that in mind, this year we say goodbye to Intel, Microsoft, and Cisco, wishing them well and thanking them for their leading returns in 2014. In their place we now have Caterpillar (CAT - Free Caterpillar Stock Report), Coca-Cola (KO - Free Coca-Cola Stock Report), and Exxon Mobil (XOM - Free Exxon Stock Report).

Sizing Up This Year’s Mutts

In order of dividend yield at the end of 2014, the Dogs of the Dow for 2015 are: AT&T (5.5%), Verizon (4.7%), Chevron, (3.8%), McDonalds (3.6%), General Electric (GE, 3.6%), Pfizer (PFE - Free Pfizer Stock Report, 3.6%), Merck (3.1%), Caterpillar (3.0%), Exxon Mobil (3.0%), and Coca-Cola (2.9%).

And quite a pack of mutts they are. Taken together, an equal position in all 10 would have set you back about 2.3% last year. Indeed, if we take out Merck (last year’s top performer among the lot, up 13.5%), you would have been down 4.1%.

How will this year’s lineup perform? That, of course, is anyone’s guess. On the plus side for equity investors, we look for U.S. GDP growth to be steadier this year, and lower oil prices might prompt consumers and businesses to spend more elsewhere. On the other side of the coin, stock valuations appear somewhat stretched and, with the Federal Reserve likely adopting less-accommodative monetary policies in the quarters ahead, any further market gains may be more difficult to come by.

Coming into this year, the Dogs’ average Price/Earnings ratio was 15.3, which compared favorably with an average of around 18.0 for all the stocks under our coverage, and supporting the value proposition of this strategy. Also, the Dogs started 2015 with their usual leg-up on the competition, providing an average yield of 3.7%, compared to 2.0% for the remaining Dow stocks.

The Long Term View

If history is any guide, the Dogs should continue to perform comparatively well. Indeed, even with last year’s “defeat”, the Dogs of the Dow strategy has beat out a balanced portfolio of all 30 Dow stocks in three out of the last five years.

Notably, excluding dividends, the Dogs averaged an annual return of 14.1% over the last five years. That stacks up very nicely to an average of 11.8% a year for an equal investment in all 30 Dow stocks. 

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.