Have the ‘dogs of the FTSE’ had their day?

When you are investing, keeping things as simple as possible is rarely a bad thing. In fact, complicated strategies employed by some professional fund managers often find it difficult to beat the markets for prolonged periods of time.

Back in 1990, Michael O’Higgins, in his book Beating the Dow, suggested that private investors could do better than the pros by simply investing in the ‘dogs of the Dow’ – the ten highest-yielding stocks in the Dow Jones Industrial Average index.

How it works

His strategy of selecting shares based on their dividend yields can make a lot of sense. Dividends have made up a large chunk of the returns from investing in shares and a high dividend yield can be seen as an indicator of a cheap share that may be out of favour. The strategy is very simple and based on four steps:

1. At the start of the year, buy the ten highest-yielding stocks in the Dow.
2. Put equal amounts of money in each.
3. Ignore them for a year.
4. Then do the same again.

This is not a buy-and-hold portfolio. You sell the shares that don’t meet the yield criteria each year and replace them with the ones that do.

Does it produce the goods?

In the updated version of O’Higgins’s book he presented some very convincing evidence for his strategy. During the 26 years between 1973 and 1998, buying the ten highest-yielding stocks delivered a total return of 7,264% – three times that of the Dow, which returned 2,408%. The strategy beat the Dow in 17 out of the 26 years, losing money in only three of them.

However, its recent performance is not so good.  According to the website dogsofthedow.com, during the 20 years to 2011 the dogs’ annual total return was 10.8%, which was exactly the same as the Dow. The dogs underperformed in 2012, but beat the Dow last year.

Has the strategy had its day? After all, share buybacks have become an increasingly popular way for companies to return cash to their shareholders, meaning that dividend yields may not be as reliable an indicator of unloved shares as they were in the past.

High dividend yields are also often a sign of distress and may signal an imminent dividend cut. Buying these shares can be a mistake. Looking at measures of dividend safety such as dividend cover and the ability of a company to grow its dividends in the future will often lead to better performance. However, this moves away from the simplicity of O’Higgins’s original strategy.

What about the ‘dogs of the FTSE’?

One problem with the Dow index is that it only contains 30 shares. It’s possible that a dogs of the Dow portfolio has become rather stale over time. In contrast, the FTSE 100, with more than three times as many shares, may offer more chances for the portfolio to change over the years.

Money Observer magazine has been monitoring a ‘dogs of the FTSE 100’ portfolio for the last 13 years. It has performed very well and beaten the FTSE 100 index in nine of them. For the 12 years to February 2013, the portfolio averaged annual total returns of 13.6%; the FTSE 100 averaged just 5.4%.

It has had bad years – such as in 2008, when lots of banking stocks scrapped their dividends – but has also had stellar ones, such as in 2009, when it gained 86.5% compared with 31.9% for the FTSE 100.

Unlike O’Higgins’s strategy, this portfolio avoids companies that are expected to cut their dividends.

This year’s FTSE 100 dogs have a heavy bias towards utilities and insurance stocks, which have mostly been paying out their profits as dividends (as shown by the low dividend cover) and for which dividend growth is expected to be modest.

This does not make for a well-diversified portfolio, but utility, pharmaceutical and big oil companies have fairly resilient earnings that have historically been good at underpinning their dividend payments. It remains to be seen whether they can outperform the FTSE 100 in 2014.

This year’s Dogs

Share Sector Ticker Price (p) Yield Cover Divi growth
SSE Utilities SSE 1,348 6.35% 1.34 4.15%
Resolution Insurance RSL 351 6.01% 1.21 1.19%
Berkeley Group House building BKG 2,632 5.73% 1.37 85.27%
Admiral Group Insurance ADM 1,306 5.21% 1.05 10.75%
United Utilities Utilities UU 677 5.21% 1.17 4.96%
National Grid Utilities NG 790 5.2% 1.24 3.21%
Royal Dutch Shell Oil & gas RDSB 2,166 5.18% 1.86 7.22%
AstraZeneca Pharmaceuticals AZN 3,587 5.08% 1.78 -1.06%
Imperial Tobacco Tobacco IMT 2,334 4.97% 1.70 9.19%
Centrica Utilities CNA 346 4.86% 1.56 4.88%
As of 3 January 2014. Yields based on last 12 months’ dividends paid