The 'FTSE Dogs' worth buying

Ever since the financial crisis broke five years ago, the so-called Dogs of the FTSE' strategy has had a pretty rough time. But in recent months, it has started to outperform the market. So is it time to back the dogs once again?

Probably the best thing about it is its simplicity. US fund manager Michael O'Higgins first coined the phrase Dogs of the Dow' around 1991. He argued that you should aim to take full advantage of the fact that other investors act in herds. They pile into popular stocks, driving the price beyond any sensible valuation.

Then when things turn sour, they indiscriminately sell off both good and bad, leaving some high-quality stocks languishing at the bottom of the market at cheap prices. It's these dogs' that a smart investor targets.

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What do dogs look like?

To find the dogs of an index such as the Dow Jones or the FTSE 100, you just rank the stocks in the index according to their dividend yields, and buy the ten with the highest yields. You then review the portfolio (every quarter is common, although you could do it less frequently) to ensure you still have the ten highest-yielders.

The logic is that, if a stock has a high yield (the latest, or forecast, dividend as a percentage of the share price), then there's a good chance that this is at least partly because its share price is unfairly depressed (the lower the share price, the higher the dividend yield, assuming the dividend stays constant).

If so, then you stand to gain in two ways. Firstly, income stocks are a good idea anyway, especially when interest rates are low roughly half the stockmarket return from the S&P 500 since the mid-1920s has come from reinvested dividends, according to Barclays Capital.

Secondly, you'll get a kicker when the share price starts to move up as the rest of the market realises that some dividend gems have been oversold. So in theory it should be a win-win trade. And because you are targeting blue-chip stocks, rather than riskier small-caps, it's a relatively low-risk strategy, at least by stockmarket standards. So does it work?

An investor's best friend?

Money Observer says that, over the past ten years, including dividends, the dogs strategy averaged a 13.4% annual return, compared to 6.5% for the FTSE 100. The magazine reselects its dog stocks once a year, and tweaks the strategy a little by avoiding any where a dividend cut looks likely at the start of the year.

Now those numbers make the strategy look like a sure thing but the trouble is many of the best gains came before the banking crisis. The credit crunch ripped into dog returns in 2007 and 2008 in particular and exposed the strategy's major flaw dividend cuts.

The collapse of the banks created several dividend traps seemingly high yields were not actually paid out. As Oliver Pursche at Gary Goldberg Financial Services puts it, the strategy "does not put any weight on financial strength or apply any fundamental analysis with regards to the sustainability of the dividend".

Trouble is, if you start to screen for these factors for example, by looking at balance-sheet strength and ratios such as dividend cover you remove one of the strategy's main strengths: its simplicity. And it can work in the right environment 2009 was a great year, for example. So the question is, should you follow it now?

Things are looking up again for the dogs. As Joanne Hart notes on Thisismoney.co.uk, the Midas Dogs' (which reshuffles its stocks quarterly, rather than annually) was relaunched last March. After a weak start, since the summer they are 7.4% higher versus just over 4% for the FTSE 100. A £10,000 investment last March would still be worth around £9,600, compared to £9,700 for the FTSE 100, but the gap is closing fast.

Where can I find today's dogs?

The table shows the FTSE 100 stocks that currently offer the best yields. We like the look of several. Vodafone, SSE and National Grid have been in and out of the dogs list for years all three offer dividends backed by very solid cash flow. Pharma stocks GlaxoSmithKline and AstraZeneca are also there, as is defence firm BAE, having fallen after its failed merger with EADS. That leaves battered insurers Aviva and Resolution and oil and gas giant Shell.

But liking these stocks individually doesn't necessarily turn the whole into a winning portfolio. As Brad Kinkelaar at Pimco notes, a high yield alone isn't enough you want stocks with a record of growing dividends. Here Vodafone scores well, but some other dogs don't. Another downside is that you'd end up with a pretty skewed exposure in terms of sectors. And a quarterly reshuffle could be expensive once you factor in trading costs.

One alternative is to go for an exchange-traded fund that targets high-yield stocks. One option is the iShares FTSE UK Dividend Plus (LSE: IUKD), which aims to track the 50 highest yielders from the FTSE 350. Its dividend yield is 3.87%, the expense ratio just 0.4% and it is up 15% year to date.

Dividend hunters should also check out Stephen Bland's Dividend Letter newsletter.