Dividend Investing Strategies – Dogs of the DOW Variations

To quickly review the Dogs of the DOW strategy, the idea is to purchase in equal amounts the ten companies within the DOW that have the highest dividend yield on the last trading day of the year. You can read more in-depth at Dividend Investing Strategies – Dogs of the DOW.

Small Dogs of the DOW uses the premise of the idea and reduces the number of companies that eventually make it into the portfolio. On the last trading day of the year one selects the Dogs, then from those companies the five with the lowest stock price are selected.

Dogs of the DOW is a simple strategy and Small Dogs of the DOW is almost as simple, which is a complaint I continue to hear. Then again, merely buying an S&P 500 index fund is as simple as it gets, yet most mutual fund managers are unable to beat it. So if a simple strategy can do what most professionals who are paid to invest other people’s money cannot then it should be a possibility for inclusion in one’s portfolio.

Below is a comparison of the Dogs, Small Dogs, and the S&P 500.

Comparisons in the 15-20 year range are helpful because over the past 15 years we have seen both the biggest financial crisis since World War II and the longest bull market in history. This means that a strategy with such a history has seen the best and worst of times, so it is not dependent upon a specific market direction. Strategies that only work during bull or bear markets are not helpful when the opposite occurs.

In this case, the shorter histories of the Small Dogs that include only a rising market do not perform as well as the Dogs or S&P 500. However, mix in the financial crisis of 2008 and it slightly outperforms both. Like its larger version, there are years of underperformance and years of outperformance.

To my mind, the differences between the Dogs and Small Dogs are not significant enough to consider. However, since the strategy works with a smaller number of companies, it may be of greater appeal to the small investor who does not wish to hold a large number of stocks.

The Foolish Four was a strategy offered by the Motley Fool. I refer to it in the past tense because they no longer endorse it. In the past, they have abandoned successful strategies, but the inclusion of the strategy in this article is more of a cautionary tale. Warren Buffett explained that he only wanted to invest in companies that he understood, and similarly, we should only employ strategies that we not only understand but also make sense to us.

At this point I will disclose that years ago I wrote a weekly column for The Motley Fool, concentrating on dividend reinvestment programs. To some degree, I had a fondness for the website, but I recognize that at times problems can arise when backtesting and data mining get in the way of reasoned approaches.

The original location of the idea for the Foolish Four no longer exists, as the explanation of the strategy is no longer on their server. All descriptions come secondhand and it appears that the strategy changed several times over the years. The simplest explanation I found was to select the Small Dogs, remove the one with the lowest price, and place 40% of the investment into the second lowest-priced stock, with 20% each in the third, fourth and fifth-lowest.

There is also an alternative description, which probably follows an alteration they had made to the original strategy, where one picks the five Dow stocks with the highest ratio of yield to the square root of the stock price, then drops the one with the highest ratio and buys the second through fifth highest. The author then emphasizes that he is not actually making this up.

Looking at the changes to the strategy it seems to me that they found a thread in backtesting and built a strategy based on that thread. I believe that when the strategy stopped working they continued backtesting in an attempt to justify it, which led to absurdity to the point where they felt the need to erase it from memory.

Much better would have been to leave the pages that explained the strategy intact, and offer a section on lessons learned. I spent many of my younger years in denial and it was not until I decided to take ownership of what I did that I “grew up.” After all, we respect those who admit their mistakes and offering an explanation of the mistake would have helped the rest of us learn. Outside of old posts on their message boards, the website is mostly silent on the strategy. As a chess player, I understand that we learn more from our failures than we do from our successes.

The official Dogs of the DOW website’s mission has been to improve on the Dogs of the DOW strategy. It offers a trove of information about it, including historical data going back to 1996 as well as information about current Dogs.

Their idea was to determine whether or not there was anything special about the number ten – the number of stocks selected for the portfolio. The Dogs strategy has the investor select ten companies but what is the significance of the number ten? Would a number other than ten make for a better portfolio? More? Less?

According to the website the answer is “Yes,” a better number of stocks in which one should invest using the Dogs of the DOW strategy is seven, and the number for those following the Small Dogs of the DOW is three. The reason the letter "X" is used is that the author wants the flexibility to adjust this number as additional information is obtained.

Over the years this reduction in the number of stocks has outperformed not only the S&P 500 but also the Dogs and Small Dogs. Below is a chart with comparisons.

This is impressive and notable. I am not a fan of holding a large number of individual companies, as the majority of my portfolio has been invested in index funds. I am more attuned to buying and holding until I either need the money or feel that a particular investment is no longer serving me, so the idea of selling just because a date has arrived is anathema to me. However, allotting a small number of stocks to this idea makes sense for consideration.

Of course, as is the case with the Dogs, there will be years when the strategy will underperform, so if one heads down this path they should do so accepting that it is a long term approach.

The general idea of the Dogs of the DOW is to have a mechanical means of selecting beaten-down stocks and buying and selling them at a specific time. The companies in the DOW are large and respected, and in the world of "should,” the ones that are currently having problems should rebound. Dividend yield is one means of identifying companies within the DOW that are unloved and will hopefully recover in the future.

However, isn’t stock price also itself a means of doing this? Perhaps it is a more direct means of identifying problem companies. I do not refer to the price of a stock in isolation, but the price relative to its 52-week high and low. If its value is near its high then it is certainly doing well, but if it is near its low then it is not performing as well as it had been. Perhaps selecting a certain number of companies from the DOW that are closer to their 52-week low than their 52-week high might make sense.

I wrote an article about the InvestMete strategy and long ago it survived my backtesting. I used the idea for about 15 years to determine how much to send to companies in my dividend reinvestment portfolio and that was successful for me, so I am very comfortable with it. How well the strategy works for companies in the DOW and how many companies should be included within the portfolio is an idea for anyone willing to backtest. Yes, this goes outside the arena of dividend investing, but none of us should be putting all of our coins into a single pot.

InvestMete is both not just strategy but also a program that will do all of the math for you, so there is no need to gather information and make 30 calculations. To run the program, enter all of the components of the DOW (AWR DOV NWN EMR GPC PG PH MMM CINF JNJ KO LANC LOW FMCB CL NDSN HRL TR ABM CWT FRT SCL SJW SWK TGT CBSH MO SYY) into the Tickers field, and enter any number for the Amount. It will take a bit of time (I have to screen scrape for the price information) but eventually a table will appear of InvestMete information for all companies.

Click the InvestMete table heading twice to sort for the highest InvestMete amounts. The companies at the top are closer to their 52-week lows than the other companies. The idea would be to purchase stock from the top listings, with the assumption that they will improve over a year.

How many companies should be chosen? Is one year the proper timeframe? I will let someone else try to figure these things out, but the general approach makes sense to me.

The Dogs of the DOW is a successful strategy for dividend investors who are seeking to outperform the S&P 500. It is a cross between one who has a buy and hold philosophy and one who would like to be more active with their portfolio. Only a long term dividend investor thinks of buying and selling once a year to be “active.”

The Dogs of the DOW X and Small Dogs of the DOW X appear to outperform this strategy, and the fewer the number of holdings may be more palatable to the small investor. The original strategy is solid, as are some alternatives to this original idea, so one should consider their perspective and determine if one of these strategies is a proper fit.

InvestMete

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