In yesterday’s column, we dissected the recent and historical performance of the popular “Dogs of the Dow” strategy.
You’ll recall that it’s one of the simplest strategies to employ.
At the start of the year, you buy an equal amount in each of the 10 highest-yielding Dow stocks. Then wait 366 days and replace that basket of stocks with the new set of high yielders.
Doing so delivered noteworthy gains last year. The Dogs, including dividends, returned 16.7%. In comparison, the Dow and the S&P 500 Index only rose 8.4% and 2.1%, respectively.
Based on that performance alone, countless investors are bound to become devout followers of the Dogs strategy in 2012. But please don’t be so naïve or lazy.
The only thing we know about the Dogs is that they’re high-yielders!
I’m not willing to put my hard-earned capital on the line based on that simple fundamental alone. You shouldn’t be, either. That’s a perfect way to get snared in a dividend yield trap.
So let’s take the time today to do our homework. Specifically, let’s evaluate the Dogs based on multiple fundamental metrics, instead of just one. And then decide whether or not the strategy warrants consideration in 2012.
Simple Business = Safe Dividends
The Dogs is a conservative, income strategy by nature. After all, it buys out-of-favor stocks (i.e. – value stocks) with above-average yields. And as I’ve said here before, if we’re investing for income, we need to learn to love boring and simple businesses.
Why? Because with fewer moving parts, there are fewer things that can go wrong. In other words, I’ll always favor companies mindful of protecting their dividends.
Another characteristic we should insist on is steady demand. Again, a company needs a steady stream of cash so it can afford to pay dividends to shareholders. That’s why I recommend sticking to industries or sectors with recession-proof or recession-resistant demand.
The good news? All of the Dogs meet both criteria. Except for General Electric.
We have the boring businesses of food, drugs/healthcare, consumer staples, telecommunications and basic materials covered. Strong economy or weak economy, we can count on demand remaining steady for each.
So from a qualitative perspective, the Dogs fit the bill as being conservative companies. Now let’s move on to a more quantitative evaluation…
Breaking Down the Dogs By the Numbers
The table below breaks down the Dogs based on five additional metrics. It then compares the averages to a broader universe of stocks, the S&P 500.
You’ll notice the chart is color coded, too. Green indicates the stock is more attractive compared to the S&P 500 based on that metric. Red indicates it’s less attractive.
Using the dividend payout ratio for the S&P 500 is irrelevant, though, since not all the stocks in the Index pay dividends. So instead, I used 80% (or lower) as the threshold, based on my seven-step system to find the safest high-yield stocks in any market.
As you can see, the Dogs are more expensive than the S&P 500 on a price-to-earnings, price-to-book and price-to-sales basis. However, they yield almost double and are cheaper on a forward price-to-earnings basis.
The 63.9% dividend payout ratio also suggests that there’s more than enough buffer for the companies to honor their dividend commitments. Even if earnings slip by double digits.
Of course, this is just a snapshot in time. If we really want to determine if the Dogs of 2012 stand a chance of matching the performance of the Dogs of 2011, we should compare them against each other.
Ask, and Ye Shall Receive
The table below is identical to the one above. Only it’s a snapshot of the Dogs of 2011 at the beginning of 2011. So it allows us to compare apples to apples.
In terms of valuation, you’ll notice that the Dogs of 2011 were a bit cheaper on a price-to-earnings basis. But other valuation metrics are in-line with the Dogs of 2012.
A glaring difference does exist, though, in terms of the average dividend payout ratio. But this shouldn’t be a surprise.
In the last year, corporate profits increased by double-digit margins for S&P 500 companies. And profits serve as the denominator in the calculation. So if the denominator increases and the numerator (dividends per share) stays the same, the ratio should decrease.
Bottom line: The Dogs of 2012 might be a bit more expensive on a historical basis. But by no means are they overpriced. And they do offer comparable and safer yields.
Add in the conservative nature of the majority of the businesses – and a slowly improving U.S. economy – and the Dogs of the Dow should indeed shine again in 2012.
Ahead of the tape,