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MONEY MANAGEMENT


Beat The Dow With The Dogs Of The Dow

02/05/02 01:33:45 PM PST
by John Devcic

Want to know how you can beat one of the broader market indexes? Here's a strategy you can follow.

After the greatest bull market in US history, stocks that were once skyrocketing have suddenly crashed to earth. This may have left many investors discouraged, but it's not the end of the world. Maybe it's time to adopt a strategy that lets you select stocks for your portfolio based on a mechanical system. The advantages of using such a system are twofold. First, you will be able to sit back and relax, since you won't need to check your portfolio every day. Second, a systemic strategy takes away the need to subjectively select stocks. The dogs of the Dow is such a strategy.

DOGS OF THE DOW

The "dogs of the Dow" strategy has been a successful one since it was introduced by Michael O'Higgins in his 1989 book Beating The Dow. In the last 10 years, it has produced an average annual return of 18.26%. O'Higgins also showed that the strategy averaged a return of 17.9% annually from 1973 to 1989. In contrast, the Dow Jones Industrial Average (DJIA) returned an average of 11.1% in the past 20 years. It lost money in only three of those years, the worst being a 7.6% drop in 1990. But since 1973 the dogs of the Dow strategy would have given you a 17.7% average annual return (see Figure 1).

Figure 1: Average annual returns. The dogs of the Dow strategy can be used as a safety net.

THE STRATEGY

The idea behind the dogs of the Dow strategy is to purchase stock in DJIA companies with the lowest price to earnings ratio and highest dividend yields. By following this strategy, you are selecting those Dow stocks that are cheapest relative to their peers (Figure 2). Although this index is made up of companies that are well-known, have strong balance sheets, and have enough capital to withstand rough times, the Dow stocks that you choose are out of favor relative to others in the index.

Figure 2: Dogs of the Dow. These are the 10 stocks of the DJIA for 2000 and 2001 with the highest dividend yields and the lowest P/E ratios. Those for 2002 are the highest-yielding as of December 28, 2001.

The strategy is straightforward and simple to follow. On the last investing day of the year, select 10 stocks from the Dow 30 that meet the criteria: high-dividend yield and low price/earnings ratio (P/E). Both statistics can be found in the newspaper or on the Internet. The dividend yield is the amount of money a company pays per share to its shareholders. The P/E is calculated by dividing the share price of a stock by its per-share earnings for the past year. The resulting number is used as a measuring stick to determine a company's value. The higher the P/E, the more likely the stock is overvalued, so a low P/E is what you're looking for. Those are the only two factors you need for selecting the 10 stocks that make up your list.

The strategy also dictates how much you need to invest. According to the dogs of the Dow method, you must invest equal dollar amounts in the 10 stocks. Then simply hold them for a year and repeat the same steps over again. The strategy requires you to hold the stocks untouched for one year, after which you can reevaluate their performance. You do not need to roll over your portfolio in its entirety every year; all you have to do is remove those stocks that no longer meet the requirements of the strategy and replace them with ones that do, remembering to purchase equal amounts of each. If you do not have enough capital to purchase 10 stocks, you can just select five.

It's not necessary to wait for the end of the year to begin using the dogs of the Dow strategy. You can start at any time and follow the rules; just make sure you hold the stocks for a year.

MAKING ADJUSTMENTS

After holding your stocks for a year, you can either sell all 10 or rebalance your portfolio. However, the cost of selling all your stocks and creating a new portfolio would be astounding, because you have to factor in capital gains taxes and brokerage fees. Rebalancing is easier. Remove the stocks that no longer fit the criteria, and replace them with some that do by allocating the equal amount of capital. If you have any money left after making the replacements, you could purchase more stock (remember, equal amounts), or consider what's left over to be your profit. It all depends on what you feel most comfortable doing.

How exactly do you balance your portfolio? It all depends on how much you have to spend. I find it most advantageous to buy equal share amounts of each stock. How many shares you purchase really depends on how much you have to invest. And of course, don't forget to factor commissions into your calculations.

CONCLUSION

If you are looking for a strategy that is mechanical and easy to understand, the dogs of the Dow may be what you are looking for. The strategy uses strong companies that are usually the titans in their fields. This allows you to be involved in great companies that have long-term growth potential, even if it's only five or 10 companies. So far, this system has proved to be profitable.

John Devcic is a freelance writer and trades stocks at home. He can be reached at jdevcic02@yahoo.com.

SUGGESTED READING

O'Higgins, Michael [2000]. Beating The Dow, HarperBusiness.

Current and past articles from Working Money, the Investors' Magazine, may be found online at Working-Money.com.



John Devcic

John Devcic is a market historian and freelance writer. He may be reached at drmorgus@gmail.com

E-mail address: drmorgus@gmail.com


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