The Dogs of the Dow is a strategy where at the start of the year one buys the 10 stocks with the highest dividend yields of the Dow Jones Industrial Average, the U.S. price-weighted index composed of 30 large companies, and sells them at the end of the year. It is really that simple, and the reason the strategy became popular after Michael B. O'Higgins presented it and coined its name in his book, "Beating the Dow," back in 1991.
In this discussion, I will present the benefits of the strategy, show the historical performance and present my following investment thesis: the strategy is becoming highly attractive again in a high rate environment where the bull market has yet to broaden despite diminishing returns since the turn of the century.
The macroenvironment led to a rebirth of the strategy
The Federal Reserve is poised to cut interest rates later this year. Historically, cuts in rates have triggered broad stock market rallies and bull markets. A bull market is characterized by its breadth, which it currently lacks despite an attempt at the end of last year to broaden the rally. This strategy has several suitable characteristics that make it likely to perform well in the near future.
The first one is that the start of a bull market is essentially a wide catch-up of valuation across the investable universe: the market participants are likely to aim first at the stocks with high dividend yields, as this indicates that its stock price is low or that it sold off recently. The assumption is, therefore, that the stocks with the highest dividend yields in the Dow are attractively priced.
Second, the reasoning behind the Dogs of the Dow is very similar to the bond market's. Indeed, when the price of a bond goes down, its yield goes up and the bond becomes more attractive. With interest rate cuts and lower fixed income yields, it is likely bond investors will search for higher income yields in the form of dividends. The Dogs of the Dow are the 10 stocks that pay the most dividends in relation to the price of a share and are, therefore, very well positioned to capture this shift of capital from the bond market toward the stock market.
Finally, another reason the strategy might be a great play is the quality of the stocks that make up the Dow Jones Industrial Average. Indeed, these blue-chip companies are better able to withstand market and economic downturns and maintain their high dividend yields due to their access to factors such as their established business and brands, access to credit markets, ability to hire top-level management and ability to acquire dynamic companies, among others. This could prove to be essential in case the current high interest rates persist (keeping the cost of debt high) or in the case they lead to a recession.
Historical diminishing returns and key risks
From 1957 to 2003, the Dogs of the Dow outperformed the index by around 3%. These stocks averaged a whopping 14.30% annual return while the index averaged 11%. The same logic of market efficiency that makes market participants shift toward higher dividend yield stocks (lower priced stocks) is also what causes this strategy to have diminishing returns over time. Indeed, because the markets are efficient, once a strategy is known to outperform, it tends to lose its edge. Unfortunately, this may be the major drawback of the strategy. Even if the strategy outperforms in the near future, it is unlikely to be a winning strategy over a long period of time.
Another key risk is in relation to the deployment of capital. The strategy requires investing a lump sum at the start of the year and reshuffle at the end of it. This causes higher brokerage costs and possible tax liabilities. Given it is a lump sum investment, the risk is larger to suffer a permanent loss if the market drops, given the strategy requires closing some or all the positions at the end of the year.
The current Dogs of the Dow provide comfort
In my opinion, it is not necessary to apply the strategy in a rigid manner in the light of the risks I have just presented. Indeed, I would carve out the obligation to close all the positions at the end of this year and leave it as a simple option depending on the investor's personal preference. The reason is the current Dogs of the Dow are attractive. The selection of stocks this year is coincidently well diversified, with six different sectors represeented across the 10 stocks. By investing in this year's selection, you will be investing in communication services (Verizon (VZ, Financial)), health care (3M (MMM, Financial), Amgen (AMGN, Financial) and Johnson & Johnson (JNJ, Financial)), industrials (Dow (DOW, Financial)), consumer (Walgreens (WBA, Financial) and Coca-Cola (KO, Financial)), energy (Chevron (CVX, Financial)) and tech (IBM (IBM, Financial) and Cisco (CSCO, Financial)). The dividend yields range from 2.90% for Johnson & Johnson to 6.80% for Verizon, providing yields that rival what can be found in the bond market, while at the same time preserving the possibility of capital gains with stock price increases.
Bottom line
Despite diminishing returns relative to the Dow Jones index since the turn of the century, further exacerbated with the Global Financial Crisis of 2008, this simple strategy is highly attractive in the current market cycle we are now entering. In 2023, most of the stock market returns were fueled by a handful of stocks. Given the interest rate cuts by the Fed expected later this year, it is likely the broader stock market will catch up. The best positioned stocks are likely to be the most undervalued ones, especially blue-chip companies that have quality financials and management in place. Given the attractive dividend yields, the markets will likely be tempted to invest in the Dogs of the Dow as they are trading at a relative discount.
