Dogs of the Dow: Howling Again?

Cover Story, by Mark Robertson, Managing Partner January 1st, 2016

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What happens if we utilize total return forecasts (instead of current yield) to go shopping among the Dow stocks? What can we learn about 1-year time horizons?

The Dogs of the Dow is a relatively passive (one year updates) strategy credited to Michael O’Higgins back in 1991. But it was not a new concept with Finance Journal articles dating back to 1951. It was simplistically based on the current yields of the Dow 30 stocks. The Motley Fool also featured a “Foolish Four” based on similar concepts but that has faded from attention over the years. The strategy was also compromised by the addition of non-dividend stocks to the Dow several years ago. What happens if we utilize total return forecasts (instead of current yield) to go shopping among the Dow stocks? What can we learn about 1-year time horizons?

2015 Results and Long-Term Performance

In 2015, the ten companies selected as Dow Dogs delivered a total return of 2.6% vs. 1.3% for the S&P 500. The returns since 1999 are shown in the accompanying table — with the Dogs outpacing the S&P 500, 7.9%-to-5.7%.

What about a little more history? Mark Hulbert documented the 50 year period leading up to 1999 in his article, However You Train It, That Dog Won’t Hunt: “Consider the many attempts to improve on the “Dogs of the Dow” strategy, which recommends buying, on Jan. 1 of each year, the 10 highest-yielding stocks among the 30 in the Dow Jones industrial average. The strategy has beaten the Dow by about three percentage points a year, on average, over the last 50 years…”

All of the documentation goes on to share stories of attempts to improve on the strategy, etc. over the years. Moments with Loeb and Rukeyser suggest that if the strategy becomes too popular and “deployed” that performance failure becomes a self-fulfilling prophecy.

I have a simple question. What’s wrong with beating the market by a couple of percentage points over the long term?

Beyond Dividends To Returns

First, we don’t believe that a 1-year forecast for any single stock can be done without a pretty broad dispersion of results. The correlation for the Dow 30 in 2015 was typical. It’s not very correlated.

Second, we do believe that results get better when measured by portfolio or dashboard. There’s strength (and error cancellation) in numbers …even relatively small numbers.

The accompanying chart displays the forecast return via analyst consensus estimates, ACE on the x-axis versus the actual results on the y-axis for the Dow 30 stocks from January 2015.

Our attention is drawn to the five highest return forecasts — those on the right of the diagram. One year ago, those five stocks were: General Electric (GE), JP Morgan Chase (JPM), Johnson & Johnson (JNJ) and NIKE (NKE). The average 1-year total return for these five stocks was 18.2%. The average 1-year total return for the five stocks with the weakest return forecasts one year ago checked in at 1.8%.

A New Iditarod? Gone Shopping For Best In Show

The stock prices and ACE-based 1-year total return forecasts in the accompanying chart are from 12/31/2015.

Yes, they’ve changed a little with the zany market gyrations of the last three weeks.

But for 2016, we’ll go with the following five selections as our Dogs based on total return forecast:

• Pfizer (PFE)
• UnitedHealth Group (UNH)
• Merck (MRK)
• Cisco Systems (CSCO)
• NIKE (NKE)

The “Diamonds” of the Dow 30 have a lot going for them. The long-term return forecast (1/22/2016) is 8.8%. Most of the companies are mature, blue chip stalwarts with an average quality ranking of 87 (Excellent). With maturity comes reduced expectations for overall growth — and the average sales growth forecast is a modest 5.0% for the Diamonds. This means that if you were to use this for part of your personal (or club) portfolios, you’d want to spend time discovering and owning some of the best small companies to bring some faster growing components to the overall portfolio.

Conclusions & Updates

If you were starting your Dogs portfolio today, the five stocks would be different (CSCO, BA, DD, PFE and GS). The 2016 market for the last three weeks has pummeled the stock prices of many of these companies and the overall 1-year return forecast for the DIA has increased from 12.1% to 21.7%.

The analyst consensus is the market is undervalued as suggested by ACE and the 1-year total return forecasts from S&P and the influential research giants like Goldman Sachs.

S&P is not as enthusiastic about the long-term values (P/FV=100%) versus Morningstar (P/FV=87%). The Value Line 3-5 year total return forecast is 8.3%.

The average return for the Top Five was 18.2% versus 1.8% for the Bottom Five. We’ll track this going forward and check back to see how the barking goes.