Why FTSE dogs can be your best friends

It usually pays to be sceptical of formulaic investment strategies, yet there is one method whose impressive results are "starting to look like more than good fortune", says Tom Stevenson in The Daily Telegraph. This is probably because it taps into a fundamental truth about markets: "they over-react".

First formulated by US fund manager Michael O'Higgins, the approach entails buying up firms that have fallen out of favour because investors have become unduly pessimistic about them, and then cashing in when this is rectified. A high dividend yield is a classic sign of a "dog", or an unpopular stock, while dividend income is a crucial element of returns.

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So O'Higgins bought the ten highest yielders in the Dow and held them for a year before re-running the screen and tweaking the portfolio. He tested the "Dogs of the Dow" method over 18 years from the early 1970s, chalking up average annual returns of 16.6% a far cry from the overall market's 10%. And by sticking to the five smallest firms thus allowing more scope for growth he improved the return to 19.4%. Applying O'Higgins to the UK has also produced market-beating returns; over 15 years in the 1980s and 1990s, the strategy yielded 20% a year, outperforming the FTSE All-Share by 4%. In the late 1990s, the record was patchier, thanks to the fashion for rip-roaring technology stocks, but over the past few years it has once again come up trumps.

In 2003, the total return from the five shares was 20% (13% from capital gains, plus an initial yield of 6%) compared with a 6% increase in the FTSE 100, while in 2004 the respective figures were 16% and 7.4%. The year to November 2005 saw an outperformance of 9%, while so far this year the five Dogs are comfortably ahead of the blue-chip index.

Investors considering a punt on the O'Higgins method should find the ten highest yielders in the FTSE 100 (www.digitallook.com can rank the index by this measure), buy equal amounts of the five with the smallest market caps, and hold for a year, says Stevenson. If the five don't inspire confidence, "that, I'm afraid is the whole point". Contrarian investing is not for the faint of heart.