DOGS OF THE DOW

Needless to say, you don't have to go far before finding an investment method based solely on choosing stocks with high dividend yields. One popular method is called ‘Dogs of the Dow', or the ‘Dow 10 Strategy'.

Dogs of the Dow is a simple mechanical system for selecting stocks that has (at times) provided superior returns to market indices. While its origins are disputed, its popularity grew following a description of the strategy in a 1991 book, Beating the Dow, by Michael O'Higgins and John Downes.

The strategy is simplicity itself. At the end of each calendar year select the 10 stocks from the Dow Jones Industrial Average (DJIA) demonstrating the highest dividend yield, then allocate 10 per cent of your investment capital to each. Hold these stocks for 12 months and repeat the process at the end of each successive year. At each annual review, sell those stocks that no longer meet the criterion and add those that do.

The concept underpinning Dogs of the Dow was proposed more than 70 years ago by Ben Graham. That is, solid companies can periodically fall out of favour due to a short-term change 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 times. Maintaining the dividend, coupled with the lower share price, results in a high dividend yield. This provides the potential for investors to be rewarded both by way of a high dividend straight up and the possibility of a later rebound in the share price. This is very different from a search for value based on real earnings growth. It's based on growth relative to expectations.

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. To date this requirement has been met through the selection criterion for a company to be included in the DJIA. But applying the Dogs of the Dow strategy to indices that include smaller, highly geared companies could introduce some risks.

The question is: does it work? After all, there's a lot riding on just one metric — the dividend yield. The test of any strategy is how it performs against the relevant benchmark. O'Shaughnessy looked at the Dogs of the Dow in his book What Works on Wall Street. He found that, applied from 1928 to 2003, $10 000 would have grown to $57 662 527 (excluding taxes and commission costs). An investment in the S&P 500 would have seen $10 000 grow to just $10 366 726.

The difference is significant but there are three problems with accepting these findings at face value. Firstly, O'Shaughnessy's findings exclude taxes and commission costs, yet these are very real costs and need to be considered when comparing it to other investment strategies. Secondly, the Dogs of the Dow strategy was born out of a process called data mining — that is, extracting favourable patterns from historical data. There is no guarantee that past patterns can be confidently applied to the future. And thirdly, popularisation of clear and simple strategies can push up prices, so wiping out the benefit.

In regard to the third point, Dogs of the Dow has been a popular strategy for over 20 years. So has this popularity impacted its efficacy as an investment strategy? The Dogs of the Dow website (www.dogsofthedow.com) compares the returns achieved using this strategy against the benchmark returns delivered by the DJIA and S&P 500 indices. Results for the one-, three-, five-, 10- and 20-year periods ending 31 December 2011 are shown in table 16.1.

On face value it looks sort of promising: it outperformed the S&P over all periods. But for the last 20 years of the comparison its performance was line ball with the Dow, not surprising since the Dow is the source of stocks for the strategy. Interestingly, research undertaken by Wharton professor Jeremy Siegel shows that the strategy works best during bear markets, and this proved to be the case following the 2008 Global Financial Crisis.

But the comparison looks quite different using the one-, three-, five- and 10-year periods ending 31 December 2014, as shown in table 16.2.

In keeping with its application to large-cap stocks, the Dogs of the Dow strategy has been adapted for use in Australia by applying it to the S&P/ASX 50 index; appropriately it has been referred to as ‘Dingoes Down Under'. However, the S&P/ASX 50 and the DJIA indices are constructed using different inclusion criteria, and this fact needs to be considered when applying it to Australian companies.

The DJIA comprises 30 large-cap stocks reflecting the spectrum of corporate activity in the US. Australia's ASX 50 simply represents the 50 largest listed companies in Australia by market capitalisation. It's dominated by several banks and miners and, unlike the DJIA, includes real estate investment trusts (REITs). Mining companies typically have low dividend payout ratios, often preferring to retain profits for exploration, capital expenditure and development activities, while REITs, which pay high distributions that have yet to be taxed, are arguably best excluded from the strategy altogether.

Before leaving the Dogs of the Dow, I want to make one more point.

Hopeful investors have been back-testing financial data for centuries in the search for simple investment and trading rules. Their efforts could be likened to the search for the pot of gold at the end of the rainbow. Interestingly, the search is not just a product of the computer age. Christoph Kurz, a 16th-century Antwerp commodities trader, wrote of his efforts to develop mechanical trading tools by back-testing data. He described his need to rise at four in the morning and:

… work as a man in the ocean with water, for our astrologers aforetime have written much, but little with reason; wherefore I trust not their doctrine, but seek mine own rules, and when I have them I search in the histories whether it hath fallen out right or wrong.⁶³

Today's investors aren't exactly basking in financial rewards from centuries of back-testing data, are they?

RECEIVING NO DIVIDEND IS OKAY

Back in chapter 14, I mentioned that dividend policy is typically treated as an instrument of wealth distribution rather than of wealth creation. Someone who breaks this mould is Warren Buffett. To date his 50-year stewardship of Berkshire Hathaway has seen shareholders delivered just one dividend. Yet during this period Berkshire's share price has increased by a factor of several thousands. Compare this with Australian telecommunications company Telstra — its share price fell by 72 per cent between 1999 and 2012 despite paying a strong and consistently high dividend for the entire period.

Clearly there should be more to the sophisticated stock picker's armamentarium than simply chasing dividend yield. After all, total returns are delivered both by dividends and capital gains. So let's discuss some of the unappreciated issues surrounding dividend policy and its impact on wealth creation.

Firstly, back to Berkshire Hathaway. Since it hasn't delivered a dividend since 1967 (and that was only 10 cents), the uninitiated might argue that Berkshire is a non-income-producing investment. But to do so fails to recognise that the company has for many years been retaining and reinvesting all of its profits at generally high rates of return. Buffett has always felt the money was better in his hands than in those of the shareholders. Hence his now famous comment about that single dividend Berkshire paid back in 1967: ‘I must have been in the bathroom when the dividend was declared.'

Despite Buffett's near five-decade stance on retaining and reinvesting all profits, he still had to field a question from a concerned shareholder at a recent Berkshire AGM. She wanted to know why, with over $30 billion in the bank and a share price of $120 000, Berkshire's directors still weren't prepared to pay a dividend. Buffett politely responded as if it was the first time he'd been asked the question. He explained that the share price was $120 000 because of years of profit retention and reinvestment. If she wanted a dividend then she was free to sell some of her stock.

So my response to the whole dividend question? As an investor, dividends are a convenient way to receive income if you rely on the money to fund living expenses. But the sophisticated stock picker should look beyond a selection process based solely on dividend yield. There are many factors to consider when assessing a stock, and the dividend it pays isn't at the top of the list.

SO WHICH METRICS SHOULD YOU USE?

Value-based metrics such as the PE and P/B ratio are popular, but advice on how useful they are is conflicting. For example, in 1992 Tweedy, Browne Company LLC, a well-known value investment firm, published a compilation of 44 research studies entitled ‘What Has Worked in Investing'. The study found that what has worked is fairly simple: cheap stocks (measured by the P/B ratio, PE ratio or dividend yield) have reliably outperformed expensive ones. It also found that stocks that have underperformed (over prior three- and five-year periods) subsequently beat those that have lately performed well. Add these findings to the studies undertaken by Dreman and O'Shaughnessy, which I've already mentioned, and you might easily become a value metric disciple.

Yet my discussion over the past four chapters has highlighted the shortcomings of these metrics. So before I move on to Part III of the book I want to try to resolve the whole issue. As a start let's consider these words from Buffett's 1992 Chairman's letter to shareholders where he said of value investing that it connotes buying stocks:

… having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield. Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth …

Buffett went on to add that:

Correspondingly, opposite characteristics — a high ratio of price to book value, a high price-earnings ratio, and a low dividend yield — are in no way inconsistent with a ‘value' purchase.

At first glance it would seem that Buffett's words contradict the findings of the Tweedy, Browne studies. Even more concerning is that both specifically name the same three metrics — price to book ratio, price earnings ratio and dividend yield. Might I add that it's no coincidence that the bulk of my discussion in this part of the book has been about these same three metrics. With these four chapters under your belt you should now be in a position to make sense of these seemingly disparate views. So let's do that.

I would suggest that the two views — of Buffett and of Tweedy, Browne — aren't contradictory at all, and that the criticism I've been delivering regarding these ratios fits with both views as well. The Tweedy, Browne studies are looking at these metrics in relation to the performance of entire portfolios, while Buffett is considering something quite different. He's saying that it's not enough to rely on these metrics when selecting an individual stock; there are bound to be exceptions to the rule.

Which returns us to the leaky fishing net analogy I made back in chapter 13. If you choose to use these metrics as part of a screening device, you're going to save a lot of time. Depending upon the demands of your screen, you're going to cut down the number of potential companies for in-depth analysis from thousands to dozens or even less. If the screen is linked to a computer program, then the time-saving will be significant.

But there's a trade-off. The screen will exclude some companies you might have otherwise chosen as investments. Your screen won't pick up stocks with high ‘value' metrics. Hence Buffett's words: ‘a high ratio of price to book value, a high price-earnings ratio, and a low dividend yield — are in no way inconsistent with a “value” purchase'.

Perhaps, then, it would be better not to refer to these as value metrics. And whether you choose to use a screen or not, it's important to remember that no screen is a substitute for in-depth stock analysis. Investors still need to go through the process of determining what a stock is worth and relating that to its current market price. So that's where we're heading in the next two parts of the book — how to go about valuing stocks.

But just before we get into it, I want to explain something. I've always found that things are best understood if you appreciate how they were derived. For example, as a student learning mathematics it wasn't enough for me to memorise a formula — I had to understand how the formula was developed using first principles. That's learning.

So in relation to the question ‘Where did the concept of stock valuation come from?' let's take a journey back in time. What you're about to read may hold quite a few surprises.

Chapter summary

• The Dogs of the Dow strategy is a mechanical stock selection method whereby the 10 stocks with the highest dividend yields are bought and held for 12 months, after which they're either reselected or rejected using the same criterion.
• Wharton professor Jeremy Siegel found that Dogs of the Dow delivers its best returns during bear markets.
• Low or no dividend stocks can still provide sound investments, as long as the companies are profitable and retained profits are reinvested at high rates of return.
• Stock screens using popular value-based metrics are likely to exclude some sound and well-priced investments.
• Stock screens are not a substitute for in-depth stock analysis.