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Journal of Indexes

The Dogs of the Dow: Headed For The Pound?

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The combination of weak 1999 performance and recent changes in the composition of the Dow Jones Industrial Average are raising doubts about the viability of the famous contrarian investment strategy. The Dogs, composed of the 10 highest-yielding stocks in the Dow, rose just 3.6% last year, including dividends - their worst showing since 1990 and one of their weakest performances ever relative to the Dow.

Hurt by a collapse in both Philip Morris and Goodyear Tire, the Dogs badly trailed the Dow, which returned 27.2% and the S&P500, which rose 21.0%. The Dow was led by low-yielding stocks like Alcoa, American Express and General Electric. Dogs practitioners generally rebalance their portfolio annually, with many making needed changes on December 31.

In the past, Dogs devotees have brushed aside sub-par annual showings, arguing that the strategy has a great long-term record and would return to form. But even some former admirers now are wondering if the strategy is finished, given the recent addition of four new stocks to the Dow.

"The number of stocks with appreciable dividends in the Dow has shrunk dramatically," says Harvey Knowles, a Cincinnati stockbroker and avid proponent of the strategy. "Times change. We're sad about it, but you have to adapt."

On November 1, Dow Jones & Co. made its second major change in the Industrial Average in less than three years, replacing four companies with appreciable dividend yields: Sears Roebuck, Goodyear, Union Carbide and Chevron. Of the four newcomers, only SBC Communications has a meaningful yield. The other three are Intel, Home Depot and dividend-free Microsoft.

The problem for Dogs followers is that only a dozen of the 30 Dow stocks now have yields of more than 1.5%. "That universe is too small," says Jim O'Shaughnessy of O'Shaughnessy Capital Management. "You'll end up investing in many of the same stocks every year."

The allure of the Dogs strategy over the years has been that it offered a frame work for buying Dow stocks when they temporarily fell from favor. Ahigh divi dend yield is often an indicator that a stock is depressed for one reason or another. Each year, losers are added to the Dogs and winners leave.

"Back in the 1960s, 25 of the 30 stocks cycled through the Dogs," says Knowles. "You've now lost the diversity in the sample, which is what made it work."

The Dogs of 2000 include eight of the same stocks as the Dogs of 1999. The two additions, SBC Communications and International Paper, will replace Goodyear and Chevron, which were dropped from the index.

O'Shaughnessy and Knowles say the solution to the Dogs problem isn't to abandon yield-based investing, which could do quite well if investors abandon prominent technology stocks and other highflyers in favor of less exciting but more reasonably priced fare. Their solution: to pick high-yielding stocks from a wider universe than the Dow. These high-yield alternatives may have merit, but what they lack is the simplicity of the Dogs strategy - a simplicity that has drawn in scads of individual investors. At the start of 1999, there was as much as $20 billion invested based on the Dogs discipline.

The current Dogs predicament is of no small interest to Merrill Lynch and three other full-service brokers, Salomon Smith Barney, Morgan Stanley Dean Witter and PaineWebber, which have successfully marketed unit trusts based on the Dogs strategy. The main trust, called Select 10, totaled about $14 billion at the start of 1999 and now has fallen to about $12 billion following net redemptions this year. Merrill and other brokers have taken in well over $100 million in annual fees from the Dogs.

"We're optimistic that if value-oriented investment strategies come back in vogue, the Select 10 will perform well," says Tim Mahoney, a portfolio manager in the unit trust area of Merrill Lynch, which administers the Select 10.

 

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