Will the Dogs of the Dow Bark or Bite in 2012?

Everyone likes a simple investing strategy. If you like dividends, there's just about nothing simpler than the following the Dogs of the Dow. But will buying these stocks help you beat the Dow Jones Industrials (INDEX: ^DJI) in 2012, or will the strategy come back to bite you with bad returns?

I'll give you my answer to that question later in this article. But first, let's make sure everyone's up to speed with what the Dogs of the Dow strategy actually is.

Know your Dogs
If you ask investors what they like in a stock, two of the most popular answers would be cheap valuations and high dividend yields. Those two factors are at the core of the Dogs of the Dow strategy.

To figure out which Dow stocks will be the Dogs for that year, you take a look at the 10 stocks with the highest dividend yields. Although there are endless variations on the strategy, the most popular method involves holding those stocks throughout the year, and then taking a fresh look the following year to see if you need to replace any of the old Dogs.

Because most Dow stocks are solid blue chip companies that don't have inordinate amounts of volatility, dividend yields tend to track relative valuation of the stocks in the average. So if a stock does well, its dividend yield usually falls, potentially kicking it off the Dogs list. But falling stocks often see their yields rise -- assuming they don't cut their dividends. That can earn those cheaper stocks a place on the Dogs list for next year.

How the Dogs did in 2011
One reason investors are paying attention to the Dogs is that the list performed very well this year. According to figures compiled by Bespoke Investment Group, the Dogs saw their prices rise by near 13% for the year as of Dec. 27. Add in the hefty dividends they paid, and you'd get an even higher total return -- easily outpacing the Dow's 6% year-to-date gain for the same period and the S&P's flat performance.

Perhaps even more remarkably, nine of the 10 stocks on 2011's list have posted gains, with McDonald's (NYS: MCD) and Pfizer (NYS: PFE) leading the way. Only DuPont suffered a loss, but with a total-return loss of just 4%, even that wasn't a terrible hit. For many of the stocks, dividends made a big boost to total return, with Merck (NYS: MRK) and AT&T (NYS: T) paying dividends that exceeded the price gains they had in 2011.

Big changes for 2012?
As it turns out, the relative lack of volatility in 2011 means that there are few changes expected to the Dogs list this year. One that's a near certainty is the return of General Electric (NYS: GE) , which has significantly boosted its dividend this year and now sports a 3.7% yield. Procter & Gamble (NYS: PG) is also poised to get onto the list for 2012, while McDonald's and Chevron would currently get the boot after their strong years.

As I see it, the Dogs in 2012 will face the same issues they usually do. Because of their high yields, pharma stocks and telecoms consistently make the list, and given that they make up four of the 10 selections, what happens in those industries has a huge impact on the list's overall performance. GE's reappearance would give both industrials and financials much-needed representation, but losing Chevron means the Dogs have no energy exposure -- which represents a big bet on falling oil prices going forward.

Keep it simple
Simple investing methods are often best, and if you're looking for a simple way to delve into individual stocks, the Dogs of the Dow strategy is a good way to get started. You won't always get market-beating performance with the Dogs, but in general, it's a portfolio that can help you sleep well at night.

But Dow stocks aren't the only place you'll find healthy dividends. Read The Motley Fool's latest special free report on dividends to get the names of 11 stocks that we think have the right stuff for dividend investors. Get your free copy now while it's still available.

At the time this article was published Fool contributor Dan Caplinger prefers cats to dogs. You can follow him on Twitter here. He doesn't own shares of the companies mentioned in this article. Motley Fool newsletter services have recommended buying shares of Pfizer, McDonald's, Chevron, and Procter & Gamble. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy has a quiet bark and never bites.

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