1 of 2
, kasto - Fotolia
Businessmen trading stocks. Stock traders looking at graphs, indexes and numbers on multiple computer screens. Colleagues in discussion in traders office.

Labeling an investment strategy a “dog” usually doesn’t instill confidence. The Dogs of The Dow has been trying to change that.

Possibly the antithesis to the Wall Street grind of research, analyze and forecast, the Dogs of the Dow strategy originally appeared in the 1992 book "Beating the Dow" by money manager Michael O'Higgins (the book was updated in 2000).

The system involves selecting 10 of the 30 companies in the Dow Jones Industrial Average with the highest dividend yield (a financial ratio that indicates how much a company pays in dividends in relation to its per-share price.) From there, investors buy those 10 particular stocks in equal amounts and hold them for the full calendar year.

“The same process takes place the following year,” said P. Jeffrey Christakos of Westfield Wealth Management in Westfield, New Jersey. “You sell the stocks that are no longer appropriate, rebalance the stocks that are still on the list and purchase the new stocks that have qualified for the list.”

While the Dogs strategy is not suited for every investor, as it inherently ignores many high-growth tech stocks and financial advisers say it should only be one piece of a diverse portfolio, the system offers a number of evident advantages stemming from its simplicity. The 10 highest dividend-yielding stocks are relatively easy to pinpoint. You can use any number of free online stocks screeners, a tool that allows investors to identify stocks according to price size, price, dividends and any number of other factors (a list of recommended screeners is available here). If even that seems like too much work, check out the Dogs of the Dow website devoted exclusively to the Dogs methodology.

Tracking is even easier, as investors just have to follow the price movement of the 10 stocks for that particular year. By year’s end, review the list to see which stocks still make the cut and readjust.

Conservative or contrarian

Although the Dogs of the Dow may seem inherently conservative on the surface —The Dow Jones Industrials are comprised of some of Wall Street’s biggest, most solid players — the system also features a contrarian approach.

Since companies rarely trim their dividends, many of the Dogs of The Dow have particularly high dividends because their stock prices have dropped of late. That not only means generous dividends (usually in the 3 to 4 percent range), but the possibility that out-of-favor stocks recover in value (hence the somewhat tongue-in-cheek label “Dogs”).

“The assumption behind the trading strategy is that once the market recognizes the value in these companies, the stock prices will rise, dividend yields on these issues will fall, investors will reap the rewards, take the proceeds and reinvest in the current group of stocks that are the most unpopular and undervalued,” said Robert R. Johnson, president and CEO of The American College of Financial Services. “In effect, the investor will always be invested in the most undervalued stocks in the Dow Jones.”

But the approach also has a conservative aspect, added David Taggart of The Macro Trader, a weekly investment newsletter.

“The basic idea is that you are buying safe, value stocks,” he said. “Dow Jones stocks are all very large companies, and if they are the highest yielders they are probably only down in price on a relative basis.”

For instance, in 2015 McDonald's coupled an approximate 28 percent price jump with a 3 percent dividend as investors expressed confidence in the chain’s ability to separate itself from the crowded fast-food market with all-day breakfast and other changes. Hewlett-Packard was the Dogs' driving force in 2013 as the tech giant recovered from consumers’ move to cloud computing, which dented HP’s data center equipment sales.

The Dogs of the Dow system has proven sufficiently popular to spawn several imitators — Invesco’s Dogs of the Dow Unit Trust is one such replica. And, if recent years offer any indication, that copycat approach has been reasonably rewarded. In a relatively flat 2015, the Dogs outpaced the Dow Jones Industrials by about 2 percentage points, according to the dogsofthedow.com website, while the five lowest price stocks of the group (so-called "Small Dogs") outperformed the Dow by more than 10 percent.

Over the past 14 years, the Dogs posted a total average return of 8.9 percent, compared to a gain of 7.6 percent for the Dow and a total return of 7.3 percent for the Standard and Poor’s 500.

The overall approach also supports the basic approach of identifying stocks that, while temporarily out of favor, have the inherent strength to recover, added Johnson.

“The long-run reversal anomaly offers credence to the anecdote that investors should buy on weakness and sell on strength,” he said. “Warren Buffett advocates a similar philosophy in arguing that an investor should be fearful when others are greedy and greedy when others are fearful.”

The caveats

But the Dogs' premise that undervalued stocks will recover their value isn't a guarantee, which is one inherent weakness in the system. Another anti-Dogs argument is that the entire group can be driven by one outstanding stock, which, once its top-flight rebound is in the books, can be dropped due to the Dogs’ parameters (2013's hero Hewlett-Packard, for example, was not on subsequent lists.)

Others argue that the Dogs by definition miss out on some of the market’s potentially top performers — a downside for investors looking for solid, long-term growth.

“Technology, a big part of the past 25 years, is almost never going to show up on this list,” said Taggart. “Even if Microsoft or Apple is down a lot for the year they still won't be top 10 dividend paying stocks. Also, since the strategy only looks at Dow stocks they have missed out on the relative outperformance of small cap stocks over the past 15 years.”

Like any investment decision, say financial pros, investigate the Dogs of The Dow methodology and results in accordance with your tolerance for risk, long-range objectives and other goals as one element in a much broader portfolio. “This strategy should be incorporated into a complete asset allocation model,” said Christakos.

“The Dogs of the Dow strategy is well suited for the income investor who wants a portfolio concentrated in high-quality, liquid stocks,” added Johnson. “It’s not well suited for the growth investor who does not need current income.”

Jeff Wuorio lives in Southern Maine, where he covers personal finance and entrepreneurship. He may be reached at [email protected] and his website is at jeffwuorio.com.