“Contrarian investors typically like out-of-favor situations where the masses have ignored or dismissed certain stocks or sectors. The theory is that barring insolvency, those same masses will eventually return, generating handsome profits for those brave enough to buy when prices were low. There are risks, primarily if the masses prove to be 100% correct, and being a contrarian requires both fortitude and patience. But human nature being what it is, and Wall Street being very much a reflection of group emotion and psychology, contrarian strategies generally work.
“One such strategy is called the Dogs of the Dow. It is surprisingly simple: buy the ten highest-yielding members of the Dow Jones Industrial Average each year. The theory is that the ten stocks with the highest dividend yields are that way because they have either quickly upped their payouts or have been oversold. Generally, the risk with the strategy is that there are often very good reasons why blue-chip stocks like Dow members are sold off severely enough to significantly raise the dividend yield. Nonetheless, by refreshing the list each year, you are automatically emphasizing companies that are undervalued relative to their blue chip peers. The strategy worked very well in 2011, with the group rising nearly 13% in price (17% adjusted for dividends). In comparison, the full Dow Jones Industrial Average rose 5.5% in price, while the broader S&P 500 was essentially flat. This makes sense, given the headlong rush for high-quality dividend yield during the year and the dearth of meaningful alternatives in the fixed-income world. Only one of the 2011 dogs, DuPont (DD), booked a loss for the year, while companies like McDonald’s (MCD), Pfizer (PFE) and Chevron (CVX) booked solid double-digit gains.
“Historically, the strategy performed very well from 1973 to the mid-1990s, posting an average annual price return of over 17% compared to 11% for the rest of the Dow Industrials. But since the start of the new century the record is more mixed, with the Dogs beating the Dow in three of the last five years and six of the last 11. Moreover, the generally flat markets for the past few years have led to less turnover in the strategy from one year to the next than has historically been the case. For instance, AT&T has been a Dog since 2007, and leads the list again this year with a 5.89% dividend yield. Fully eight of 2011’s list also make it into this year’s group.
“By and large, 2012’s Dogs are a very interesting group of companies. McDonald’s and Chevron no longer qualify, replaced this year with General Electric (GE) and Procter and Gamble (PG). Despite truly awful price performance in 2011, no financial stocks qualified for the 2012 Dogs (JP Morgan Chase missed the cut by only a mere nine basis points), although it is worth noting that General Electric is often considered a financial stock with an industrial veneer. GE boosted its dividend 70% over the past two years, while returning Dogs Intel and Pfizer hiked their payouts by 33% and 11%, respectively, in 2011. Interestingly, Microsoft (MSFT) is 11th on the list, with a 3.1% yield at the start of the year. For old hands in the financial business, this is astounding: Microsoft used to be the ultimate growth stock.
“The Dogs of the Dow is a simple strategy that provides investors with blue-chip quality, market-beating yield, and sector diversification. At a time when dividends are favored over fixed income assets (as interest rates are expected to stay low), the potential for higher price appreciation than what’s available in the broader index itself is strong.”
Stephen Leeb, PhD., Leeb’s Income Performance Letter, 2/1/12