Dogs of the Dow: Mangy Mutts or an Investor's Best Friends?

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The "Dogs of the Dow" theory involves buying equal amounts of the 10 Dow stocks that had the highest dividend-to-price ratio during the previous full year. It has become a popular investing strategy thanks to its simplicity, and for the first three months of 2014, the best of the Dogs have outperformed the S&P 500. But not everyone thinks it's a Best of Breed technique.

Drawbacks Among the Mangy Curs

First, let's clarify this strategy. Plenty of stocks pay dividends -- money you get just for owning them on payout days. If the dividend amounts to a relatively high percentage of the stock price, that's an indicator that the shares may be undervalued -- and thus poised to rise.

This year, the 10 are AT&T (T), Chevron (CVX), Cisco Systems (CSCO), General Electric (GE), Intel (INTC), McDonald's (MCD), Merck (MRK), Microsoft (MSFT), Pfizer (PFE) and Verizon (VZ).

Telecom stocks like AT&T and Verizon tend to show up in the Doghouse year after year mainly because they are traditional high-yielding "widows and orphans" stocks with dividend yields of 5.25 percent and 4.46 percent, respectively.

People expect the Dogs to outperform the overall market. Some years -- like last year -- they do. However, the 2013 group results were skewed by the performance of one stock, Hewlett Packard (HPQ), which doubled. Most of the other Dog stocks were down on the year or had single-digit percentage rises. In 2012, some of the Dogs jumped through their hoops like champions, but among the other 20 Dow components were stocks like Bank of America (BAC) and Home Depot (HD), which soared too.

As of the market close on Thursday, three of the ten Dogs were down year-to-date: Verizon, down 2 percent; Chevron, down 4.8 percent; and the worst performer, General Electric, down 6.4 percent. The Best of Breed of the Dogs are Merck, up 12 percent; Microsoft, up 9.4 percent; Pfizer, up 5.9 percent, Cisco up 2.2 percent. This leaves AT&T up 1.5 percent, Intel up 1.6 percent, and McDonald's, up 0.5 percent -- small rises that amount to being practically flat.

To be fair, the rest of the Dow 30 aren't looking so hot, with Caterpillar (CAT) up 11.6 percent and Johnson & Johnson (JNJ) up 7.3 percent as the sole non-Dog Dow stocks rising more than 5 percent.

So this brings up the other drawback to Dogs of the Dow theory. Of those ten names this year, you have two competing telecoms, two Big Pharma and three old tech balanced by an arguably weak consumer goods stock McDonald's, one conglomerate and one energy name. Until the big banks start raising their yields to historically high pre-crisis levels, the Dogs of the Dow will remain unbalanced, like a circus dog on a ball.

Man's Best Friend

Of course, these dogs fetch better than average yields. These are all big-cap names that are solid businesses, if maybe a little boring. Although Dogs of the Dow theory has been around for 35 years and outperformed the S&P 500 mostly, its 17.7 percent average return is not guaranteed, underperforming during the tech go-go years of the late 1990s.

Nonetheless, it is a simple system. If you hold for at least one year and a day, you will stay in the long-term capital gains tax bracket. And honestly, some names are there year after year, so those could stay in the portfolio, and the reinvested dividends will improve the overall return. At least six stocks have been faithful pups since 2011: GE, Verizon, AT&T, Merck, Intel and Pfizer.

Theoretically, over the last few years, rebalancing (thanks to the six remaining in the doghouse) would only involve eight trades annually. It hardly gets more simple than that.

Some of these dogs are Dividend Aristocrats, having raised the yield for more than 25 consecutive years like Chevron and AT&T. Even McDonald's, the dog least likely to "hunt" (meaning to move much) is a Dividend Aristocrat, having raised its yield 37 years straight.

Finally, you don't have to implement a Dog of the Dow strategy on Jan. 2. It might be wiser to wait for a selloff and rescue those pups after all the other new Dog owners leave the pound.

As part of a larger portfolio strategy that includes some small- and mid-caps, foreign and financial stocks, Dogs of the Dow is a fairly low-risk, high-yield strategy with minimal time involved. It could work out well longer term with its several Dividend Aristocrats but don't think all these Dogs will hunt -- in other words, move much -- every year.

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