Will 2012 be the year of the dog?

We like to keep investing simple and few strategies are simpler than building dogs' portfolios. The best known are the Dogs of the Dow' and Dogs of the FTSE'. They are based on one simple premise: the highest dividend yielding stocks are most likely to offer the best growth. So will the strategy deliver in 2012?

How to pick dividend dogs

The dividend yield is simple to calculate. You take the annual dividend as a percentage of the current share price. So if a firm paid out 10p per share over the past 12 months (interim and final dividends combined) and the current share price is £2.50, then the yield is around 4%, ie, (10p/250p) x 100%. Analysts also forecast a yield for the next 12 months. However, this can be pretty unreliable should a forecast dividend get cut.

So how does the strategy work? To pick this year's top dogs, rank FTSE 100 or Dow Jones 30 stocks by their dividend yields and pick the top ten. Then sit back and wait.

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What should happen next

High dividend yields are potentially good news for two reasons. Firstly, you are getting a solid income from the share, assuming the dividend is maintained. In the current climate, where finding income that comes close to matching inflation is tough, that's attractive.

But it's only half the story. A high yield is also, to an extent, the result of a low share price. In the example above, had the share price been £1, the yield (assuming the annual dividend is the same 10p) rockets to 10%. So a very high yield can point to a potential bargain. Investors are prone to mood swings and herd behaviour. If their attitude towards a beaten-down stock with a juicy yield changes, it could spring back fast and offer some capital appreciation on top of its already-generous payout.

Because you are picking these stocks from blue-chip lists, such as the FTSE 100 or Dow Jones 30, you should be picking up reasonably solid, well-established names. So in theory at least, the risk of a horrendous share-price collapse is small compared to fishing around in the small-cap market.

2011 a mixed bag

So how does it work in practice? Last year saw a transatlantic split. The dogs picked from the Dow Jones at the start of the year saw their prices rise by close to 13% on average (up to 27 December), according to Bespoke Investment Group. That's on top of some generous dividends paid in 2011. This gain trumped the 6% available from the Dow Jones and near-zero from the S&P 500. Nine of the ten dogs posted gains and only one DuPont suffered a share price loss. But throw in a decent dividend and you get an overall gain of 4% not bad.

Closer to home the strategy looks less convincing. For example, the Money Observer portfolio launched in February gained just 0.34% up to 6 January. Behind that number lurk some serious duffers insurers Aviva and RSA dropped nearly 33% and 21% respectively. The top riser was GlaxoSmithKline, which surged by just under 30%.

The quarterly adjusted Daily Mail Midas portfolio has struggled too. At the last review at the end of November, Joanne Hart said that their dogs were "a sorry bunch". Between August and November it dropped from a value of £5,196 to £4,961.

Since launching with a notional £10,000 investment in April 2007, it is down by more than 50%. Fund managers have fared badly with a similar strategy the Henderson Rowe Dogs FTSE 100 fund is down 3.9% over the last year versus a 3.6% drop for the FTSE 100.

The common thread? A portfolio of UK dogs is more heavily exposed to battered financial stocks than its US equivalent and has suffered accordingly.

So should you buy dogs?

The evidence for the long-term success claimed by the strategy's fans is mixed. Money Observer states "the average annual performance over 11 years is 13.9%, compared to 6.6% for the FTSE 100 index".

However, Citigroup (quoted by Neil Hume in the FT) has analysed stockmarket leaders and laggards from 1996 onwards. It found the dogs strategy only beat the alternative running with your winners, which will tend to have lower yields in three years out of 15. Those three years were "big market and macro-economic turning points" in 2000, 2003 and 2009, according to analysts Jonathan Stubbs and Adrian Cattley. So are we at one of these now?

The economy's not for turning

In Europe, the answer is no as the banking and sovereign debt crises roll on. Capital Economics forecasts a UK double dip in 2012, suggesting another tough year for UK dogs stocks, such as hedge fund Man Group and inter-dealer broker ICAP.

Over the pond things look brighter unemployment data have improved, making the US the best of a bad bunch. For US investors, a dogs strategy may pay off in 2012, but we'd be wary about piling mechanically into the highest yielders with no regard for dividend safety.

Defensive blue chips with exposure to rising American consumer confidence are worth holding (consumer staples stock Procter & Gamble and drug company Merck are examples from the current dogs list), but in this uncertain climate we'd stay selective.