Will the 'Dogs' have their day?

Contrarian investing works. If you buy when everyone else is selling, and vice versa, you'll tend to do well. One classic investment strategy, the 'Dogs' of the Dow (or the FTSE, for UK investors), involves simply buying the least popular stocks in an index, then waiting for them to bounce. It's worked well for investors in the past. For example, the Daily Mail's Midas Dogs portfolio doubled between 2001 and 2007 while the FTSE rose 17%. But can it deliver in 2010?

What is a traditional Dog?

Defining 'least popular' is key. The classic Dogs strategies focus on stocks with the highest dividend yields. The dividend used can either be the latest reported (the historic figure) or an estimate of the next 12 month's payout (a forward figure). Assuming constant dividends, a growing yield suggests the share price is weak (yields rise as share prices fall). Given that faddish stockmarket investors often unduly punish unfashionable companies, this suggests a stock is ripe for recovery.

How have the Dogs done recently?

Not so well. Had you invested £10,000 in the FTSE 100 in April 2007, by the end of November of this year you would be down to £8,075. But had the same £10,000 gone into the FTSE Dogs (reviewing the portfolio every three months to ensure it contains the ten highest yielders), you would have been down to just £5,039 by the same date, report the Daily Mail's Joanne Hart and Andy Brough. "Halving in value over 30 months is underwhelming, to say the least." And although an average income yield of 6.6% is not bad with the Bank of England base rate at 0.5%, it's not enough to compensate.

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The US version hasn't done much better. So far in 2009, using the ten highest-yielding Dow Jones 30 stocks to create a Dogs of the Dow portfolio "has underperformed the Dow by quite a wide margin", says the Bespoke Investment Group. The average price change for the ten Dogs has been 11.2% in 2009, against 23.1% for the Dow and 29% for the 20 "non-Dog" components of the index. That pattern holds for 2008 too. So is there any point in pursuing a Dogs strategy at the moment? Yes. But you need a different approach.

Another way to pick Dogs

Neil Hume on FT Alphaville highlights a strategy from Darren Winder of Cazenove. Instead of choosing Dogs based on dividend yield, you just go for the FTSE 100's ten biggest fallers in terms of share price. For 2009, this would have been a "very profitable investment strategy". An equally weighted basket of the worst-performing stocks of 2008 "would have gained 130% this year, outperforming the wider market by in excess of 100%". So could this year's biggest losers see a similar rally in 2010?

The importance of turning points

This year cyclical stocks have surged. The top ten performers includes eight natural resources stocks (mining firm Kazakhmys, up 430%, is the top performer), plus the odd wild card, such as luxury fashion group Burberry (up 156%). That's mainly because there was a huge turning point in sentiment this year. Once it was clear that the financial world hadn't quite ended in 2008, and that central banks would flood the world economy with dollars, pounds and euros, asset prices including the price of commodities took off. That, coupled with commodity stockpiling by China, is what has driven many of the FTSE's top performers this year. But another, rather different, turning point could be just around the corner. That means picking Dogs selectively could pay off in 2010 too.

Why Dogs might prosper again

As Hume notes, to bet against this year's FTSE winners and pick instead the much more defensive Dog stocks that have struggled, is to "back problems in emerging markets and a meltdown in commodity prices".

That might not be such a long shot. As Paul Hill points out on page 11, there is plenty of evidence to suggest that China has built too much capacity. Its appetite for commodities could easily dry up at some point next year. Meanwhile, the longer central banks wait before reversing quantitative easing (a mixture of interest-rate cuts and money printing designed to stimulate demand), the worse the eventual impact will be when they do get around to tightening.

What to buy

Despite being among the 15 worst performers of 2010 and therefore prime Dogs candidates we don't like the look of banks such as RBS or Lloyds. There are too many possible hidden balance-sheet nasties still lurking in that sector (due to reckless pre-crunch lending), which are currently being disguised by their ability to borrow so cheaply from the Bank of England.

However, more attractive Dogs include several blue-chip utility companies. Utilities should be able broadly to maintain earnings even in weak economic conditions, so they are good defensive plays for tough times. Water firm Severn Trent (LSE: SVT) has fallen 16% this year, but now offers a forward dividend yield of 6.8% and trades on a forward price/earnings ratio of 10.3 times.

Meanwhile, National Grid's (LSE: NG.) drop of 6% during 2009 puts it on a yield of 5.9% and a p/e of 11. And one of Paul Hill's recent tips, defence firm BAE Systems (LSE: BA.), may be down 10% this year, but comes with a yield of 4.6% on a p/e of 9.1. As Cazenove's Winder notes, these firms have "the characteristics which have fallen out of favour this year, such as yield and a defensive earnings profile" exactly the features that "will once again need to be valued by UK investors" in 2010.