Although predated by other strategies that focused on high-yield Dow components, what eventually became known as the Dogs of the Dow system first gained wide notice in the early 1990’s thanks to Michael B. O’ Higgins’ book, Beating the Dow (Harper Collins Publishers, 1991). The strategy is based on the theory that beaten down stocks of higher quality companies will usually bounce back and, in so doing, can sometimes generate above-market returns. Stocks are chosen by taking the top 10 highest yielding stocks at the end of the year from the 30 names that make up the Dow Jones Industrial Average. The rationale behind this screening process is that these yields are elevated only because the issues have temporarily fallen out of favor (hence the “Dogs” moniker).  A year later, the portfolio gets rebalanced based on the current stocks that make the list.

While there are thousands of trading strategies available, among the most important hallmarks of a good system are clearly defined entry and exit points. Also, ease of use makes it more likely that the method will be adhered to. On these fronts, the Dogs of the Dow passes with flying colors. Applying the strategy is simplicity itself, with no need for any complicated calculations or extensive time-consuming research. Indeed, the required information is readily available from numerous online and printed sources. At the start of the year, an investor merely takes the 10 Dow stocks with the highest indicated yield and divides his other money evenly among them. No further action is required until the following year, whereupon the prior year’s holdings are sold (if necessary) and the process is repeated.

Although it’s been traditionally advocated that the strategy be initiated at the start of the year, in practice, an investor can use any date, so long as consistency is maintained. Starting on the first of the year just makes it easier to remember, and allows for direct performance comparisons with broader market indices.
The strategy is appealing on several levels. As opposed to momentum-based systems that focus on stocks that are already outperforming the markets, the DOGS strategy goes slightly against the tide, giving it a contrarian slant. It also draws value-oriented investors who are looking to buy stock at discounted prices.

Thus, at its core, it aims to follow the age-old market axiom of buying low and selling high. While this is excellent advice in theory, it is far more difficult in practice. But because the DOGS is a mechanical system, with predefined entry and exit points, one clear benefit is that it helps take the emotional aspect out of decision making. Also, it’s easy to implement and eats up very little time. There’s no need to be a market gurus, sifting through hundreds of reports and opinions, and analyzing reams of data.

Meanwhile, downside risk is partially addressed by the fact that the components of the Dow are widely held, large cap, blue chip stocks of companies with extensive financial resources, and thus a higher chance of recovering. And, even if the temporarily downtrodden don’t bounce back right away, the better-than-average dividend yields help ease some of the pain.  (Sometimes, it should be noted, the top-10 selection will include stocks that have not necessarily suffered, but simply those that generate above-average yields as a rule.) Also, as these companies are generally diversified in terms of products and markets, the likelihood that they will entirely go out of business is relatively small.

Finally, from a money management standpoint, the one-year holding period lowers the potential tax bite, as Uncle Sam gives preferential treatment to long-term capital gains. Meanwhile, low portfolio turnover helps keep trading costs down. Indeed, Citigroup (C), General Electric (GE), Pfizer (PFE), EI DuPont de Nemours (DD), Verizon Communications (VZ) and JPMorgan Chase (JPM) each made the list in all five of the past five years.

Of course, it does have its drawbacks. Like all mechanical systems, it doesn’t work every year, and sometimes, not for several years in a row. As a result, lack of patience could easily prompt many an investor to jump ship, and compounding is an important component of the system.

Additionally, the method does not do well when growth stocks are in favor, and it doesn’t protect you from systemic market weakness. As recent times have proven, sometimes things get so bad that even Dow stocks can be out of favor permanently. Also, even the most well-run outfit will occasionally have to cut dividends, shaving off some return. As an added consideration, while dividends are currently taxed at a maximum rate of 15%, that could change in 2011, further eroding any advantage.

Finally, the system faces the same fundamental issue incurred by all value or contrarian based strategies,  namely, that “undervaluation” is largely an opinion rather than a fact. That is, even with the most iron-clad argument that a specific equity or group of stocks should go up in price, you still have to wait for the market to agree with you, which can be sooner, later, or never.  In contrast, most momentum-based systems rely on cold hard facts. That is, a stock or group of stocks is either doing better than the market, or not.

When the system was first brought to the public’s attention, the key attraction was that, over an extended period, it had outperformed the DJIA by several percentage points a year. Although the advantage was usually relatively small in any given year, compounding helped magnify the returns over long periods. And, while the method didn’t turn up a winner every year, it did so often enough to attract a good deal of attention. What usually happens with trading systems, however, is, if they become too widely followed at any given time, they tend to lose their effectiveness. After all, if everybody rushes out to buy the DOGS, they’re no longer unpopular, right? At one point, when the method’s reputation was flying high, several open and closed end funds were created to mimic the strategy, and billions of dollars were sent chasing after the formerly unwanted pups. Sure enough, as the system acquired a wider following, its performance advantage lessened. As a consequence, the strategy failed to live up to its original expectations in ensuing years. 

From 2000 through 2009, the system beat out a buy-and-hold strategy for the Dow in five out of the 10 years, but cumulative returns lagged, and it hasn’t outperformed since 2006.  To be sure, the past decade was far from ordinary. For example, value-based investing fell heavily out of favor during the tech bubble years, when profits and dividends no longer seemed to matter. Then, the more recent financial meltdown took a heavy toll on a wide swath of the market, including such Blue Chip names as General Motors (GM, both for its auto troubles and its financing arm, GMAC), General Electric, (which also has a large financial component), Citibank, and JPMorgan Chase. 

However, this underperformance in recent years may turn out to be a good thing, as fewer followers should help restore the system’s advantage. Indeed, so far in 2010, it’s done a little better than simply holding the Dow 30. Based on year-end yields, 2010’s portfolio is made up of AT&T (T), Boeing (BA), Chevron (CVX), DuPont, Home Depot (HD), Kraft Foods (KFT), McDonald’s (MCD), Merck (MRK), Pfizer, and Verizon Communications.

The search for market beating systems has proven to be eternal. Though none can generate outstanding results every year (for long), many are usually abandoned due to complexity, time and effort required, or simply lack of resolve on the part of investors. On those counts, the DOGS system offers an attractive alternative. It’s easy to understand, intuitively appealing, simple to maintain, and a comparatively low-cost method for potentially above-market gains. Perhaps most important, while the DOGS may not always be overly profitable, the discipline of rule-based investing should help keep the average investor from realizing outsized losses.