Winning With The Underdogs

There are many strategies that an investor can use to help him or her make money on Wall Street. Most of the time, the major drawback to following any stockpicking strategy is that it can become time-consuming. Following on the heels of the success and popularity of the "Dogs of the Dow" is a strategy called the "Underdogs of the Dow." For those of you who are not familiar with the Dogs of Dow, simply put, it's when you buy equal amounts of the previous year's 10 highest-yielding Dow Jones Industrial Average ( DJIA) stocks and hold them for a year. The Dogs of the Dow is an easily understood and easy to implement strategy. That goes for the Underdogs of the Dow strategy as well. Take a closer look at the Underdogs, starting with what might be an introduction for some and a refresher for others.

THE DOW: WHAT IS IT?

The Dow Jones Industrial Average ( DJIA) was first published in 1896. It is a stock index made up of the 30 most widely held companies. In order to compensate for stock splits and such, the index is weighted. Weighting simply means that the movement of higher-priced stocks has a bigger impact on the DJIA than lower-priced ones. The components of the DJIA do change from time to time, depending upon market conditions or mergers, at which point the editors of The Wall Street Journal make those changes. So what is the Underdogs of the Dow strategy about?

UNDERDOGS OF THE DOW

Like the Dogs of the Dow, the Underdogs of the Dow is a simple strategy. The Underdogs strategy requires that you purchase equal amounts of the 10 worst-performing Djia stocks from the previous year. Like the Dogs of the Dow, you hold these stocks until the end of the year, where you adjust as necessary, tossing out the stocks that performed better than others and looking for those that were hammered that year. Obviously, the Underdogs strategy is contrarian in nature, which can be difficult for most investors. Contrarian investing requires that you look away from where the majority is placing their money. The adage of buying low and selling high is truly what the Underdogs of the Dow is all about.

Following the strategy, you have no choice but to buy low, as you are purchasing stocks that have been beaten down or underperformed the previous year. The "selling high" part is the bonus if the strategy works. The advantage of this type of contrarian investing is that you would be buying relatively healthy companies, since they would be DJIA components. What are the 10 DJIA stocks that make up the Underdogs of the Dow this year?

THE 2006 UNDERDOGS OF THE DOW

These are the 10 worst-performing DJIA components from last year that make up the 2006 Underdogs of the Dow:

General Motors (GM)
Verizon Communications (VZ)
International Business Machines (IBM)
Disney (DIS)
Pfizer (PFE)
Du Pont (DD)
Wal-Mart (WMT)
3M (MMM)
Alcoa (AA)
Home Depot (HD)

And these were the 10 worst-performing DJIA components from the year before that made up the 2005 Underdogs:

2005 UNDERDOGS OF THE DOW

 Merck (MRK)                                 4%
 Intel (INTC)                               -8%
 General Motors (GM)                       -48%
 Pfizer (PFE)                              -11%
 Coca-Cola (KO)                             -1%
 Alcoa (AA)                                 -4%
 Hewlett Packard (HP)                       38%
 3M (MMM)                                 -3.5%
 Microsoft (MSFT)                           -1%
 SBC Communications/AT&T              No change 

Looking back at the returns for the 2005 Underdogs is eye-opening. There were a total of two winners and seven losers, with AT&T posting no change for the year. The biggest loser was GM, which lost nearly half of its value, while HP moved off the list by gaining 38% for the year.

The year before, there were some familiar Underdogs:

2004 UNDERDOGS FO THE DOW

 Eastman Kodak (K)                        28%
 At&t (T)                                 -1%
 Merck (MRK)                             -28%
 SBC Communcations (SBC)                   4%
 Johnson & Johnson (JNJ)                  25%
 Wal-Mart (WMT)                          0.5%
 Microsoft (MSFT)                          9%
 DuPont (DU)                              10%
 Coca-Cola Co. (KO)                      -16%
 Proctor & Gamble (PG)                    12% 

The 2004 Underdogs of the Dow performed much better than the 2005 Underdogs did. MRK posted back-to-back losses. There were seven winners and three losers. The biggest of the three losers was MRK, which lost 28% for the year. From these results, it is clear that 2004 was a better-performing year for the Underdogs than 2005.

There is evidently some overlap of the companies in the Underdog list from one year to the next. Three of the companies that were on the Underdog list in 2005 made it to the list in 2006. This just goes to show that the performance of a company in one particular year doesn't really say much about how it will perform the following year.

A stock making it in the Underdog list may not sound like much of an accomplishment, which is the inherent risk of this strategy. You could be holding onto a company that may be underperforming, at least for a while.

As you can see, this is a rather passive strategy. You don't worry about what happens to the stocks from January to December. At the close of the last trading day of the year, you look and see what the profits, if any, turned out to be.

As I mentioned, when you use the Underdogs of the Dow strategy you will be buying cheaper stocks, or stocks that have been beaten down the previous year. The positive view toward the fact that you will be buying stocks that have been underperforming is that because they are all Dow components, it is likely that the companies are financially sound. You have some measure of security.

There are underlying reasons why these stocks were beaten down the previous year. The beauty of the Underdogs strategy is that it is truly automatic and removes the emotion that most investors feel when picking stocks. You are not worried about anything except what the stock price did the previous year. In that case, you simply buy because they were the DJIA's laggards from the year before. Nothing else about them is important. This removes any personal judgment on your part, and you do not need to worry about deciphering earnings reports or stock chart formations.

The Underdogs of the Dow can be a very useful strategy when you aren't sure what stocks to buy but would like a measure of security that the stocks you are buying are fundamentally sound investments.

When you are looking at this strategy, it is important to point out the major drawback. Interestingly, its major drawback is also its major attraction: you have to buy stocks that were losers the year before, and there is usually a good reason for these stocks to be down.

In the end, if you look at any strategy, it will have some kind of drawback. The Underdogs of the Dow is another way to pick stocks. It is easy to follow and only requires you to be active twice a year: at the end of the year and the beginning. You cannot ask for a simpler strategy than that.

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