Have the Dogs had their day?

Many investment strategies work well for the first few investors to adopt them, but unravel once everyone else cottons on.

However, one has stood the test of time largely unscathed: the 'Dogs of the FTSE'. This is a UK variant of a well-known US stock-picking technique called 'Dogs of the Dow', devised by Michael O'Higgins.

The premise is simple enough. Because investors tend to act in herds and are prone to get greedy when times are good, or panic en masse when fear stalks the market, share prices always overreact (surging on good news and plummeting on bad).

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The Dogs strategy takes advantage of the latter and assumes that bad news is always reflected in a high dividend yield (the annual dividend divided by the current share price as a percentage). Dividends are determined by the directors and generally only reset every six months, whereas the share price changes every day.

So if a company has declared a total dividend of 10p and its share price is £2.50, the dividend yield is 4% (10 x 100/250). If the next day the share price collapses to just £1.20, then the yield rockets to more than 8% (10 x 100/120). Dogs theory says that whatever the bad news that caused the collapse, the market has overreacted.

So if you buy now, you are getting an income return of 8% better than a bank account with a strong possibility of capital gains on top when the share price recovers as investors realise that the bout of selling was overdone.

How to hunt down Dogs

There are several variations on the basic Dogs theme. Peter Temple recommends you build your portfolio by first finding the ten highest-yielding companies in the UK market (this is easy to do on an investment tools website, such as Digital Look). Then simply put an equal sum of money into the five with the highest yield. How long you wait before reviewing the portfolio depends on how active you want to be.

Temple suggests leaving it untouched for 12 months before recalculating the constituents. Thisismoney.co.uk follows a more active approach and reviews its Dogs portfolio, containing all top ten yielding shares, every three months, selling shares that have dropped from the list and replacing them with any new arrivals. There's not necessarily anything wrong with this, but bear in mind that more of your return will be eaten up by commissions, bid-to-offer spreads and stamp duty. So the overall strategy is straightforward but does it work?

Can the Dogs keep outperforming?

Here the news is a little mixed. Long term, the results look good Michael Higgin's approach to US stocks outpaced the Dow Jones by an average of 5% per year from 1961 to 1995. Meanwhile, over here, between 2002 and 2006, Peter Temple comfortably outperformed the UK market three times out of four.

The problem, and it's a big one, is the last six months. Had you started in March this year, things would not be looking too pretty just now Tom Stevenson's March selection in The Daily Telegraph was BT (down 12% since then), Vodafone (up 22%), Compass (down 15%), GKN (down 21%) and EMI (up 9% before being taken over in August by Terrafirma). That's an average fall of 3.4%, compared to a gain of about 5% for the FTSE 100.

What's more, were you to buy the top five today based purely on dividend yields, your selection would start with quite an eye-opener. Top dog is Northern Rock (yield 29% although the dividend has understandably been suspended for the time being), followed by three house builders Barratt Developments (7.66%), Taylor Wimpey (7.39%) and Persimmon (5.97%) plus Royal Bank of Scotland (6.79%).

While most of these were solid performers until this summer, their high dividend yields could now be interpreted as a very necessary incentive (the average yield on the FTSE 100 is only 3.2%) for taking the risks involved in buying into either UK banks, given the ongoing credit crunch, or UK house builders, given that all the latest indicators point to a downturn.

Today's Dogs look like turkeys

And there's another problem although any further share-price declines will be cushioned to some extent by the juicy dividends on offer, there is no guarantee that these dividends will be maintained indefinitely should things get really nasty for the UK economy over the next 12 months.

Widening the selection to include the top-ten yielding stocks doesn't give much reassurance either; you would then be adding F&C's commercial property trust (a sector in big trouble, as we commented last week), another three banks (HBOS, Bank of Ireland and Barclays), plus Britannia Insurance.

So while the Dogs strategy may have paid off nicely in the benign economic environment of recent years, it may not be the best route to follow now that times are getting harder. Instead of signalling oversold stocks, high yields may well now be warning of future dividend cuts. In short, most of today's Dogs of the FTSE look more like turkeys.