The Dogs of the Dow Strategy is Fundamentally Flawed

This article on The Dogs of the Dow was written by Net Net Hunter member Bryan Shealy. Bryan worked in the inventory business for 5 years which gives him an edge in net net investing. Article image (creative commons) by Marco Verch, edited by Broken Leg Investing.

Have you turned on the TV recently and watched the DOW streaming across the screen?

There is so much conversation and analysis done on the DOW it can be dizzying. Why so much focus on an index that only has 30 of the largest US stocks in it? This is an archaic way of valuing the stock market when there are literally thousands of companies that are available to invest in! Why then do so many people invest in these large companies?

For one, the market does seem to be shrinking and large companies keep growing. There have even been fewer IPOs. The access to cheap capital is fueling mergers and share repurchases and the popularity of dividend stocks has never been greater!

Make way for the resurgence of a popular strategy known as the Dogs of the Dow.

What is the Dogs of the Dow?

The Dogs of the Dow was popularized by the book Beating the Dow. The strategy involves investing in the 10 highest dividend yielding stocks, within the Dow, at the beginning of the year. Then repeat every year after rebalancing, with the new highest dividend yielding stocks.

This strategy hopes to beat the Dow using a contrarian strategy. The idea is that these large companies move through cycles of overvaluation and undervaluation. These are large proven companies that most likely will not fail in the near future. The focus is that when a Dow company has a high dividend its stock price has dropped. This offers an opportunity to buy one of these proven companies at a discount, since obviously it's in a down cycle and will surely be out in a few years.

Why are more people not using this strategy? It sounds amazing, as I can buy great out-of-favor companies on the the cheap! What could be so bad about sitting back and collecting fat dividends?

The downside of Dogs of the Dow

Well, lower returns, for one. Don’t get me wrong, I love dividends. Nothing is better than collecting a stable passive income. Well. Almost. How about growing your portfolio upwards of 25%? Smaller companies have much greater growth potential than the large companies on the Dow.

Take Apple as an example. The largest company in the world, it currently stands at around 3% of the S&P 500 and nearly 5% of the Dow. If this company were to double in value just 5 times it would account for the entire value of the S&P 500. This seems incredibly unlikely, but small and micro cap stocks do this all the time!

The strategy can also get extremely volatile and amount to putting all of your investment dollars into just a couple of stocks. There is a common belief that investing in small companies is incredibly risky. In fact it seems like large institutions are purposely trying to underplay the benefits of investing in small stocks.

This may be because they are trying to earn your business and can't invest in these stocks themselves!  But, The Dogs of the Dow strategy asks followers to invest in as few as 2 stocks in any given year. 2! This could be a decent move if you have the skill and knowledge of Charlie Munger, but it’s unwise for mere mortals. From this standpoint your risk is exceptionally high of choosing a Dow company that may even drop out of the Dow, which they sometimes do, pushing down prices due to delisting and destroying your profit potential. All it takes is one stumble for those average returns to crumble.

If you are going to invest yourself there are many more superior alternatives.

What strategies are better than Dogs of the Dow?

There are tons of strategies available to the retail investor. A few of them here at Broken Leg Investing include: Pay Daddy, Ultra, Simple Way 2.0 and Acquirer's Multiple. These strategies focus on much smaller stocks and are proven strategies. For example, Evans portfolio has done exceptionally, as you can see here: http://www.netnethunter.com/hunter-fund/

hunter fundEvan Bleker's 4 Year Portfolio Returns Versus the Russell 2000 and NASDAQ (Source: Net Net Hunter)

Evan focuses on some of the smallest and cheapest companies in the market. His portfolio has returned approximately 28% CAGR whereas the Dogs of the dow strategy would have returned around 8.6% CAGR since the year 2000. It may be more volatile but it's arguably less risky for these great returns!

Take a look at the risk analysis of Evan’s portfolio. The downside deviation handily beats the Nasdaq. It has also had fewer negative periods of profitability. In the full year of 2017 the Dogs of the Dow underperformed the Nasdaq. If I were investing my own hard-earned cash I would not stand for a return lower than Evan’s, let alone the Nasdaq!

RISK ANALYSISEvan Bleker's Portfolio Risk Using Net Nets and Ultra Stocks (Source: Net Net Hunter)

Evan of course follows a net-net investing strategy. This focuses on paying a price for a stock that is less than its net short-term assets. If you love dividends this strategy can even include high-paying dividend stocks likely to appreciate in value.

The strategy I’m talking about is the one mentioned above: Pay Daddy. These are stocks selling below net current asset value and still pay a dividend! If you are looking for a true dividend contrarian strategy this is a much more valuable one. While not as profitable as Evan’s pure net net strategy, the Pay Daddy strategy can yield around 20% CAGR. I’ll take 10% higher returns than that dog strategy any day.

Other questions about Dogs of the Dow

I can’t help but continue to wonder why this is a strategy at all? There are so many unanswered questions. Like why doesn’t the strategy take into account payout ratio? I would assume payout ratio would be an important metric when looking at a stock valuation. If the payout ratio is above 80% I would fear for the safety of my principle. Who cares if the stock has almost a 5% dividend!

There are some Dow stocks that pay out less than 30% of their cash flow. Take a look at Apple. It’s payout ratio currently hovers at around 22% and has a dividend of just 1.42%. If you were to triple the payout ratio, this would probably be the biggest dog in the entire Dow! It would most certainly be a much safer one too.

The Dogs of the Dow strategy attempts to beat the Dow and actually succeeds in doing so most of the time. If all you are trying to do is beat the Dow then maybe that strategy is for you, but wouldn't you want even greater returns for your time and effort?

Conclusion

From a risk standpoint the dogs of the dow may seem like a safe bet, afterall you are buying cheap. Cheap according to what metric?

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