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This article appeared in the February 2011 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.
By Michael Kemp, author
You may have heard about the Dogs of the Dow. Also known as the Dow 10 Strategy, the Dogs of the Dow is a simple, mechanical system for selecting shares that historically has provided superior returns to market indices. Its origins are disputed but its popularity increased following a description of the strategy in Higgins and Downes's 1991 book, Beating the Dow.
The strategy is simplicity itself. At the end of each calendar year, select the 10 companies from the Dow Jones Industrial Average (DJIA) demonstrating the highest dividend yield. Then allocate 10 per cent of your investment capital to each.
Hold the shares for 12 months and repeat the process at the end of each successive year. At each annual review sell those that no longer meet the criterion and replace them with those that do.
A 70-year-old idea
The concept underpinning the Dogs of the Dow strategy was proposed more than 70 years ago by the so-called "Father of Value Investing", Ben Graham. That is, solid companies can periodically fall out of favour with the market because of short-term changes in investor sentiment or business conditions. This usually results in a depressed share price.
Despite this, management will often maintain the dividend, reflecting their optimism of a return to favourable conditions. Given the maintenance of the dividend and the lower share price, a higher dividend yield will result. This provides the potential for the investor to be rewarded both by way of a high dividend and a recovering share price.
Central to the success of the strategy is the capacity for the selected companies to recover from periods of adversity. Thus large-cap companies with strong balance sheets are best suited. So far this requirement has been met through the selection criterion for a company's inclusion in the Dow Jones.
If the Dogs of the Dow strategy is to be applied to other indices, broad-based indices that include smaller companies should be avoided.
Does it work?
Value investors utilise two principal techniques for identifying undervalued companies. These are:
- Comparing intrinsic value to market price.
- Ratio analysis. Financial ratios are calculated for the companies under review, then compared in order to select the company or group of companies with the most favourable ratios.
Clearly Dogs of the Dow falls into the second category. However, one of its weaknesses is that it relies on just one ratio - dividend yield. But the test of any strategy is how it performs against the appropriate benchmark.
James O'Shaughnessy, in his best-selling book, What Works on Wall Street, looked at the Dogs of the Dow strategy. He found that if applied from 1928 to 2003, $10,000 would have grown to $57,662,527 (excluding taxes and commission costs). By comparison, an investment in the S&P 500 would have seen $10,000 grow to the significantly lesser amount of $10,366,726.
There are two risks in interpreting this result at face value:
- The Dogs of the Dow was born out of a process called data mining - that is extracting patterns from historical data. There is no guarantee that past patterns provide rules that can be confidently applied to the future.
- The popularisation of strategies that allow for the clear and simple identification of target companies can potentially push up prices, so negating the usefulness of the strategy.
The Dogs of the Dow has been a popular strategy for the past 20 years. Has this popularity affected its efficacy as an investment strategy?
The Dogs of the Dow website compares the returns achieved using this strategy with those using the benchmark DJIA and S&P 500 indices. Results for one, three, five, 10 and 19 years to December 31, 2010 are shown in the table below.
|INVESTMENT||1 Year||3 Year||5 Years||10 Years||19 Years|
|Dogs of the Dow||20.5%||-0.5%||6.2%||4.6%||10.5%|
Although not statistically conclusive, these results might indicate that the popularisation of the strategy has reduced its efficacy. In its defence, research undertaken by Wharton Professor Jeremy Siegel shows the strategy works best during bear markets and this proved to be the case after the global financial crisis.
How to apply it in Australia
In keeping with its application to large-cap companies, the Dogs of the Dow strategy has been adapted for use in Australia by applying it to our S&P 50 Index. Appropriately it has been referred to as "Dingoes Down Under". However, the S&P 50 and the DJIA indices are constructed using different inclusion criteria and this needs to be considered when applying the strategy to Australian companies.
The DJIA comprises 30 large-cap companies reflecting the spectrum of corporate activity in the United States. Australia's S&P 50 Index simply represents the 50 largest listed companies by market capitalisation. It is dominated by banking and mining companies and, unlike the DJIA, includes Australian Real Estate Investment Trusts (A-REITs). Special comment needs to be made in relation to the latter two investment classes.
Mining companies tend to have low dividend payout ratios, preferring to retain earnings for exploration and development. Thus, despite their recent strong performance, they have fallen outside the scope of the strategy. On the other hand, A-REITs, which make large distributions, are best excluded from the strategy entirely.
Australian dividend yields
The 10 companies in the ASX S&P 50 Index that currently demonstrate the highest dividend yields are shown in the table below. Therefore, if you want a conservative, simple investment strategy that has provided good returns in the past, then happy investing. But remember this is not a short-term strategy, so stick with it.
(Editor's note: Do not read the list below as share recommendations. As always, do further research or consult your adviser before investing in the companies mentioned. They may not suit your investment goals.)
|COMPANY||ASX CODE||DIVIDEND YIELD|
|National Aust. Bank||NAB||6.5%|
About the author
Michael Kemp has had a long career in Australian financial markets. Following the release of his first book, Creating Real Wealth, in 2010, he now works as a freelance financial writer.
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