A punt on the “Dogs of the Dow”

Simplicity is a virtue when it comes to investment strategies and they don't come much simpler than the "Dogs of the Dow", first outlined by asset manager Michael O'Higgins in his 1991 book, Beating The Dow. Put equal sums into the ten highest-yielding stocks in the Dow Jones index at the start of the year. Hold for a year, sell up, then repeat.

Two key assumptions underlie the approach. Firstly, that big blue-chip Dow stocks are unlikely to cut their dividends, so the downside risk is limited. Secondly, that dividend yields are a better measure of value than earnings. Earnings can be manipulated, but it is hard for a company consistently to pay out more than it can afford. In the 2000 edition of the book, O'Higgins argues that the strategy would have returned 18% a year from 1973 to 1998, compared with 13% from the market.

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However, there are a few caveats. Firstly, the best returns did not come from the highest-yielding stocks (those in the tenth decile), but from those just below this category (in the eighth and ninth deciles). That highlights the risk that a very high yield may reflect the risk of a pending future dividend cut. Secondly, in the years between 1990 and 2006, the best stocks had high yields but also low payout ratios in other words, dividends were sustainable and had room to grow.