Does a “Dogs” investment strategy make sense?

One of the most straightforward and widely known investment strategies is the "Dogs of the Dow", based on a book published in 1990 called Beating the Dow by Michael O' Higgins. After the market closes on the last day of the year, buy equal dollar amounts of the Dow Jones index's ten highest-yielding companies. Hold on to them for a year, and then repeat the process.

The strategy is a form of value investing, with a high dividend yield reflecting a poorly performing, unpopular stock in the bargain basement. The idea is to profit from the high yield and the capital gains as the stocks bounce back. Money Observer has been doing a UK version, the (ten) Dogs of the FTSE 100, since the turn of the century.

Over the past 17 years the Dogs portfolio has produced an annual average total return of 13.7%, compared with the FTSE 100's 6.1%. As for the original Dogs, backtesting the data revealed that in the 26 years between 1973 and 1998 the strategy outstripped the index by a factor of three. But since then it has been much less impressive, achieving a total yearly return of 8.6% between 2000 and 2016, compared with the Dow's 6.9%.

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The problem? For starters, the annual portfolio rejig would incur substantial trading costs; another technical objection is that with equity buybacks becoming an increasingly popular way for companies to return cash to shareholders (especially in the US), the dividend yield isn't quite as representative as it was when it comes to pinpointing beaten-down and unloved shares. Remember too that a high dividend yield can be a sign of trouble as well as of good value. In 2017, for instance, shares in one of the dogs, Capita, sank by 40% when the dividend was cancelled amid a profit warning. The outsourcer's travails ensured that the Dogs portfolio produced a total return of just 8% in 2017, and failed to beat the index for the fifth time on record.

This brings us to the main problem dogging the Dogs: if just one stock can make the difference between under- and outperformance, it reflects the fact that a portfolio of ten companies is too narrow to be considered diversified. It will tend to be skewed towards a handful of sectors, because trouble sometimes affects entire industries, or investors marking down a stock will be inclined to punish its peers too. The Dogs Portfolio of 2014 gave investors a heavy weighting in technology (30%) and healthcare (20%). Similarly, half the last FTSE dogs comprises utilities (SSE, Centric, and National Grid) with 20% in oil (BP and Shell). A larger portfolio with a wide spread of industries is a better long-term bet: seek out an income fund rather than going to the Dogs.