The Dogs of the Dividend Aristocrats

The "Dogs of the Dow" is an investment strategy that involves selecting a portfolio of the 10 highest dividend-paying stocks from the Dow Jones Industrial Average based on a specific criterion. The strategy is relatively simple:

1. Select the 10 stocks with the highest dividend yields from the DJIA. The dividend yield is calculated by dividing the annual dividend per share by the stock's current market price.
2. Invest an equal amount of money in each of the selected stocks, regardless of their individual stock prices or market capitalizations.
3. Maintain this portfolio for one year, at which point you re-evaluate the portfolio and repeat the process.

The underlying idea of the strategy is to identify and invest in established companies with relatively high dividend yields. The assumption is these companies may be temporarily undervalued, and their dividend yields have risen due to their stock prices being depressed. The hope is these stocks will recover in the coming year, potentially delivering capital appreciation along with the dividend income.

Investors who follow the Dogs of the Dow strategy typically implement it at the beginning of each calendar year, selecting the 10 highest-yielding stocks from the DJIA as of that date. This strategy capitalizes on stocks' tendency to revert to the mean and has a contrarian and a value bent. According to the website Dogsofthedow.com, since the turn of the century, Dogs of the Dow X has an average annual total return of 9.9%, noticeably better than the Dow Jones Industrial Average.

While the strategy is straightforward and easy to implement, it is important to note that it is mostly a passive approach and does not take into account fundamental analysis or specific market conditions. As with any investment strategy, there are no guarantees of success and past performance is not indicative of future results. Investors should carefully consider their individual financial goals and risk tolerance before adopting this or any other investment strategy. The Dogs of the Dow strategy has had periods of success, but it is not a guaranteed path to investment profits. Its performance depends on various factors, including market conditions and the specific stocks selected. Investors should conduct thorough research, consider their financial goals and risk tolerance and consult with a financial advisor before implementing this or any investment strategy.

Dogs of the Dividend Aristocrats

Many variations of the strategy can be built. One strategy which I explore in this discussion is to build a "dogs" strategy on selecting a subset of the most undervalued Dividend Aristocrats. The strategy is as follows:

Start with the Dividend Aristocrats of the S&P 500. These are the high-quality companies that have grown dividends for at least 25 consecutive years, with most doing so for 40 years or more. These companies have stable earnings, strong fundamentals and a track record of profit and growth. This strategy has a proven track record of enduring market volatility by capturing gains in rising markets while minimizing losses in falling markets. In selecting these company's I use the holdings of the ProShares S&P 500 Dividend Aristocrats exchange-traded fund (NOBL, Financial), which are listed in Appendix 1. Currently there are 65 companies in the list. (I have entered these companies into a GuruFocus Portfolio, which can be accessed via this link, if you are subscriber).

First, select the most undervalued subset from the Dividend Aristocrats. For this step, I used the GF Value criteria to select the most undervalued companies from the list. I ran the 2023 Dividend Aristocrat portfolio through the All-in-One Screener and selected the subset of the list which showed up as "significantly undervalued" (GF Valuation: 3) or "possible value trap, think twice" (GF Valuation: 2) i.e., a GF Value rank of 3 or below. (Note: One company - Kenvue Inc. (KVUE, Financial), which was split off from Johnson & Johnson (JNJ, Financial) was excluded as it is a recent entry into the index and the system does not have enough data on it to evaluate.)

Figure 1: Screen shot of GuruFocus Portfolio

The GF Value is the current intrinsic value according to the GF Value Line, which represents the current intrinsic value of a stock derived from a valuation method based on historical multiples, past performance and analysts' future earnings projections.

GuruFocus believe the GF Value Line is the fair value that the stock should be traded at. The stock price will most likely fluctuate around the GF Value Line. If the stock price is significantly above the GF Value Line, it is overvalued and its future return is likely to be poor. On the other hand, if it is significantly below the GF Value Line, its future return will likely be higher.

Figure 2: Screen Shot of All-in-One Screener

Based on the relationship between the current stock price and the GF Value, GuruFocus provides the following evaluations:

• Possible Value Trap, Think Twice
• Significantly Overvalued
• Modestly Overvalued
• Fairly Valued
• Modestly Undervalued
• Significantly Undervalued

I ended up with following subset, which I will call the Dogs of the Dividend Aristocrats.

These companies all have illustrious records and pay growing dividends, but are undervalued according to GuruFocus. If theory is correct, over the course of the next year, these stocks should be reverting to the mean.

Conclusion

The Dogs of the Dividend Aristocrats strategy builds off the proven Dogs of the Dow strategy using the Gurufocus All-in-One screener. With the help of the screener, I selected the eight most undervalued candidates (i.e., significantly undervalued or possible value traps) from the original list of 65 Dividend Aristocrats. These 65 Dividend Aristocrats are already some of the most proven and steady companies on the U.S. market or they would not be on the full list. In my opinion, GF Value criteria is a superior metric than just selecting the highest-yielding candidates in the original strategy. Also this strategy selects from the S&P 500 a much larger set than the DOW 30.

If the theory holds out, these companies should eventually revert to the mean and become fairly valued over the long term, thus delivering superior total returns. The theory expects that given the long and profitable history of these companies, current challenges, whatever they are, will be solved in time. However, there is always the possibility that the decline in one of the companies' fortune is permanent. The theory suggests that after one year, the portfolio should be rebalanced with the next set of candidates.

Appendix 1.
Dividend Aristocrats of the S&P 500 (from the NOBL ETF)