Buy the dogs of the Footsie

published 16 January 2007

Buying cheap stocks paid off again last year. Across the world, value investing concentrating on stocks with low earnings multiples and book value or high dividend yields trumped growth investing, a strategy focusing on popular, fast-growing shares. Morgan Stanley Capital International's Global Value index gained 22.2%, compared to a mere 13.8% advance for its world growth index. Richard Bernstein of Merrill notes that typical value plays, such as stocks with low price-to-cash-flow ratios and high yielders, were among the best of 40 different strategies it tracked in the US in 2006.

The value approach has now come up trumps for seven years in a row, says John Authers in the FT. The ascendancy of private equity may help to explain why it has kept going for so long: classical value investors look for a "catalyst" to release hidden value, and private equity funds looking for bargains to buy have evidently provided such sparks. Growth investing may seem due for a comeback indeed, value investor Jeremy Grantham noted in the FT last November that value stocks were at a record valuation relative to the rest of the market. However, whatever happens in the near future, countless studies have shown that, over the longer term, investors are better off "buying and holding cheap, unfashionable shares" than chasing "the darlings of the day", says Peter Shearlock in The Sunday Times. "It seems obvious, but it's not what most people do." A good New Year's resolution, then, says Shearlock, is to "stop worrying about the direction of the market" and concentrate purely on value.

One straightforward value strategy worth considering is the O'Higgins, or "dogs of the FTSE", method. This exploits the fact that markets tend to overreact and works on the premise that oversold stocks will regain ground as investors realise they may have been unduly pessimistic, says Tom Stevenson in The Daily Telegraph. Of the ten highest-yielding FTSE 100 stocks a high yield denotes a "dog", or an unpopular stock-pick buy the five with the smallest market capitalisations (small companies have more scope for growth) and hold them for a year. The dogs method produced market-beating returns in the 1980s and 1990s and its total returns have eclipsed the overall market's in the past four years too. Stevenson's five for 2006 are Bradford & Bingley, DSG, Alliance & Leicester, Scottish & Newcastle, and Kingfisher.