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Will the “Dogs of the Dow” Outshine in 2013?

With 2013 now in full swing, it’s high time we tackle one of the biggest annual questions in dividend investing: “To Dog or not to Dog?”

I’m referring, of course, to the popular investment strategy known as the “Dogs of the Dow.”

If you need a quick primer, the way it works is simple: Near 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 a new set of high yielders. Lather. Rinse. Repeat.

Sound too good or too easy to be true?

Since the Dogs outperformed the Dow and the S&P 500 in every decade except the 1930s and 1990s, on a broad historical basis, the answer is a resounding, “It’s true. And it works like a charm.”

But when you drill down and look at the more recent past, some skepticism appears well-deserved.

On a year-by-year basis, the Dogs outperformed in 2000, 2001, 2002, 2006, 2010 and 2011. They traded in lockstep with the Dow in 2003. And they underperformed in 2004, 2005, 2007, 2008 and 2009.

Now we can add 2012 to the list of underperforming years, too, with the Dogs of the Dow closing out the year with an annual gain of 9.6% (with dividends reinvested) versus 11% for the Dow.

If you’re counting, this means that for the last 13 years, the Dogs beat the Dow just under 50% of the time. Hardly an impressive track record.

Last month, Louis Basenese weighed in on the Dogs’ recent spottiness and future prospects, concluding that “if we’re going to embrace the strategy in 2013, we need to do some more homework first. Specifically, we need to evaluate the Dogs based on multiple fundamental metrics, instead of just one.”

And that’s exactly what I’ll be doing today…

Weighing the Dogs, Pound for Pound

Simple, conservative and recession-resistant businesses aren’t always equally cheap investments. The table below comparing valuation metrics for the Dogs of the Dow and the S&P is proof.

Note that the color coding shows exactly where the Dogs fall short of the S&P – green being better and orange being worse…

As you can see, when it comes to price-to-earnings, price-to-book and price-to-sales, these Dogs are anything but cheap. They’re a bargain compared to the S&P in only one respect – forward price-to-earnings.

The observant among you are already objecting, “But there’s more to it than just valuation!”

Indeed, although these stocks are relatively overpriced, the two remaining figures – yield and dividend payout ratio (DPR) – might be enough to make up for their cost.

Case in point: The average yield for this year’s pack of Dogs is down from the last by a notch (3.8% versus 4.0%), but compared to the S&P’s 2.3%, it still outshines.

What’s more, 2013’s average DPR of 72.1% is below the 80% threshold that separates stocks in danger of unsustainable distributions from safe ones. And that’s before excluding AT&T’s (T) massive 233% DPR from the calculation for unfairly skewing the numbers. Without it, the average dips even lower, to 52%.

The manageable DPR is even more important when you consider that there are a number of aggressive dividend growth stocks in mix. And that the turnover rate for the Dogs of the Dow is on the low end, with many stocks running in the pack for years on end.

Translation? If you play this strategy for the long haul, it’s good to know that, on average, not only are your dividend payments going to rise, they’re not going to end up hitting a ceiling and getting cut down.

McDonald’s (MCD) five-year average dividend growth rate of 20.40% matched by a healthy DPR of 52.8% is a prime example.

Bottom line: Yes, the 2013 Dogs of the Dow are a tad on the expensive side. But with yields far above the S&P average, aggressive growers in the pack and sustainable payouts, these down-and-out blue chips have more than a fighting chance to outshine in the coming year.

Safe investing,

Ryan Anders