Dogs of the Dow: Howling Again?

Might The Dogs of the Dow Be Howling Again?

The Dogs of the Dow is a relatively passive (one year updates) strategy credited to Michael O’Higgins back in 1991. But it was not a new concept with Finance Journal articles dating back to 1951. It was simplistically based on the current yields of the Dow 30 stocks. The Motley Fool also featured a “Foolish Four” based on similar concepts but that has faded from attention over the years. The strategy was also compromised by the addition of non-dividend stocks to the Dow several years ago.

What happens if we utilize total return forecasts (instead of current yield) to go shopping among the Dow stocks?

2015 Results and Long Term Performance

In 2015, the ten companies selected as Dow Dogs delivered a total return of 2.6% vs. 1.3% for the S&P 500. The returns since 1999 are shown in the accompanying table — with the Dogs outpacing the S&P 500, 7.9%-to-5.7%.


What about a little more history? Mark Hulbert documented the 50 year period leading up to 1999 in his article, However You Train It, That Dog Won’t Hunt: “Consider the many attempts to improve on the “Dogs of the Dow” strategy, which recommends buying, on Jan. 1 of each year, the 10 highest-yielding stocks among the 30 in the Dow Jones industrial average. The strategy has beaten the Dow by about three percentage points a year, on average, over the last 50 years…”

All of the documentation goes on to share stories of attempts to improve on the strategy, etc. over the years. Moments with Loeb and Rukeyser suggest that if the strategy becomes too popular and “deployed” that performance failure becomes a self-fulfilling prophecy.

I have a simple question. What’s wrong with beating the market by a couple of percentage points over the long term?

Beyond Dividends to Returns

First, we don’t believe that a 1-year forecast for any single stock can be done without a pretty broad dispersion of results. The correlation for the Dow 30 in 2015 was typical. It’s not very correlated.

Second, we do believe that results get better when measured by portfolio or dashboard. There’s strength (and error cancellation) in numbers …even relatively small numbers.

The accompanying chart displays the forecast return via analyst consensus estimates, ACE on the x-axis versus the actual results on the y-axis for the Dow 30 stocks from January 2015.

Our attention is drawn to the five highest return forecasts — those on the right of the diagram. One year ago, those five stocks were: General Electric (GE), JP Morgan (JPM), Johnson & Johnson (JNJ), Microsoft (MSFT) and NIKE (NKE).

The average 1-year total return for these five stocks was 18.2%.

The average 1-year total return for the five stocks with the weakest return forecasts one year ago checked in at 1.8%.

A New Iditarod? Gone Shopping For Best In Show

The stock prices and ACE-based 1-year total return forecasts in the accompanying chart are from 12/31/2015.

Yes, they’ve changed a little with the zany market gyrations of the last three weeks.

But for 2016, we’ll go with the following five selections as our Dogs based on total return forecast:

  • Pfizer (PFE)
  • United Health Group (UNH)
  • Merck (MRK)
  • Cisco Systems (CSCO)
  • NIKE (NKE)

The “Diamonds” of the Dow 30 have a lot going for them. The long-term return forecast (1/22/2016) is 8.8%. Most of the companies are mature, blue chip stalwarts with an average quality ranking of 87 (Excellent). With maturity comes reduced expectations for overall growth — and the average sales growth forecast is a modest 5.0% for the Diamonds. This means that if you were to use this for part of your personal (or club) portfolios, you’d want to spend time discovering and owning some of the best small companies to bring some faster growing components to the overall portfolio.

Dow Diamonds: Chronicle. Time series display of return forecast (PAR), quality ranking and ETF (DIA) price over the last few years. Quality has been steady. The summer/autumn of 2015 price dip may have suggested a multi-year buying opportunity (relatively high return forecast) at the time.

Price Performance: DIA. Chart courtesy of This 20-year perspective on the Dow 30 stocks underscores the reality is that even blue chips come with speed bumps and plateaus. The 18-year annualized total return for the DIA exchange traded fund is 5.8%. Yes, Virginia. That lost decade was a beast. RSI: For more on meaning/understanding, see: Relative Strength Index ROC: Annual rate of change. See: ROC.

Conclusions and Updates

If you were starting your Dogs portfolio today, the five stocks would be different (CSCO, BA, DD, PFE and GS). The 2016 market for the last three weeks has pummeled the stock prices of many of these companies and the overall 1-year return forecast for the DIA has increased from 12.1% to 21.7%.

The analyst consensus is the market is undervalued as suggested by ACE and the 1-year total return forecasts from S&P and the influential research giants like Goldman.

S&P is not as enthusiastic about the long-term values (P/FV=100%) versus Morningstar (P/FV=87%). The Value Line 3-5 year total return forecast is 8.3%.

The average return for the Top Five was 18.2% versus 1.8% for the Bottom Five. We’ll track this going forward and check back to see how the 2016 stocks check in on December 31, 2016. For now, that’s an interesting difference and — in my opinion — collectively supports/affirms our analysis methods and gives us a nudge to study and own some of these blue chippers for as long as it makes sense to do so.

Dow Jones 30 Industrials: The Long & Short. (January 21, 2016) Projected Annual Return (PAR): Long term return forecast based on fundamental analysis and five year time horizon. Quality Ranking: Percentile ranking of composite that includes financial strength, earnings stability and relative growth & profitability. VL Low Total Return (VLLTR): Low total return forecast based on 3-5 year price targets via Value Line Investment Survey. Morningstar P/FV: Ratio of current price to fundamentally-based fair value via S&P P/FV: Current price-to-fair value ratio via Standard & Poor’s. 1-Year ACE Outlook: Total return forecast based on analyst consensus estimates for 1-year target price combined with current yield. The data is ranked (descending order) based on this criterion. 1-Year S&P Outlook: 1-year total return forecast based on S&P 1-year price target. 1-Yr “GS” Outlook: 1-year total return forecast based on most recent price target issued by Goldman Sachs, Merrill Lynch, JP Morgan Chase or Morgan Stanley.

Note: The price targets from Goldman Sachs (“GS”) are from public releases and represent a partial sample. The price target is logged as of the most recent public analyst report. Although every effort is made to keep this information as current as possible, some of the ratings may not reflect more recent research and updates. Some of the older Goldman Sachs estimates (>6-9 months) have been adjusted using more recent price targets from Merrill Lynch, JP Morgan, Morgan Stanley etc.

Dogs of the Dow: Arbitrage Hedge Demonstration

It bears repeating.

For the year ended 12/31/2015, the Top Five stocks using our Dogs of the Dow approach based on total return delivered a collective performance of 18.2%. The Bottom Five checked in at 1.8%.

This is a candidate for an arbitrage strategy. For more, here’s the Wikipedia version.

We’ll play along with the following dashboard during 2016. We’ll assume that some investing firm (think hedge fund) will allow us to short the Bottom Five by selling $200,000 worth of each stock on 12/31/2015. Simultaneously, we’ll take the proceeds from those five transactions ($1,000,000) and spread that among the Top Five.

The current results through 1/22/2016 are shown in the accompanying chart.

Dogs hedge 20160122r

Ghosts of P/Es Past


As 2013 winds to a close … and the Value Line Arithmetic Average soars some 34.2% over the trailing 12-months, we can be thankful that most of us benchmark against the S&P 500 (30.0%) or the Wilshire 5000 (31.1%).

30% seems like a lot … and it is.

But it’s still stock price recovery mode from the damage incurred during the Great Recession and I won’t be surprised to see/hear pundits like Jeff Gundlach out with remarks resembling “if the stock price advance in 2012 was unwarranted … 2013 redefined unworthy.” We’ll be taking a closer look at the internals of the surge (including the hint/nudge that when the Value Line average tops the others, there’s a pretty good chance the flaky stocks are churning — and they are/were.) We’ll also do the year-end close out with a look at the clarions and barometers next week.

But for now, the profitability forecasts for year-end 2013 (nearly actuals at this date) and the 2014 expectations are not all-that-great … and they continue to weaken.

What’s not weakening are P/E forecasts … and they’re getting frothy.

And that’s where the foundation for any house-of-cards is usually found. In the face of rising interest rates (supply-and-demand competition for stocks) that foundation could well be sinking sand.

Companies of Interest

Materially Stronger: Arris (ARRS), NuSkin (NUS)

Materially Weaker: Commercial Vehicle Group (CVGI), Fuel Systems (FSYS), Titan International (TWI), Bioscrip (BIOS), Alaska Communication Systems (ALSK)

Market Barometers

The median Value Line low total return forecast is 3.4%, unchanged from a week ago.

Cisco Systems (CSCO): Watch, Wonder, Wait

Cisco Systems (CSCO) appeared in this week’s update under the flag of “Materially Stronger” and at the same time was mentioned in a series of articles that called into question the long-term viability or sustainability of some of their product lines (hardware). We talk about threats and opportunity analysis a fair amount here, so it seems like a good time for a deeper dive and closer look at Cisco Systems.

The company is #11 in the MANIFEST 40 so it’s no stranger around here.

CSCO also serves as something bigger than a poster child for rhino confusion. Why? Because when the stock price reached $80-90 back at the advent of Y2K, the company was the most STRONGLY RECOMMENDED stock on Wall Street at a time when our return forecasts were screaming SELL based on a DOUBLE-DIGIT NEGATIVE PAR! The CSCO situation (and madness) was the centerpiece of an article I wrote for Better Investing at the time.

Let’s break it down. First, “Materially Stronger” in our weekly updates simply means that the Value Line analysts have given the long-term low price forecast a significant boost. What is significant? We’re watchful for 20-25% step changes (up or down) and we share these as “flags” with our community.

The long-term low price forecast for CSCO of $30, translates to a long-term low total return forecast of 11.7%.

Business Model Analysis

Profitability Analysis

Under assumptions of a 6% sales growth forecast, a projected net margin of approximately 20% and an average P/E expectation of 13x, a case can be made for a projected annual return of 11.7%.

From the Business Environment to Skeptical Rhinos

FBR Capital Downgrades Cisco — Sees Reductions in Hardware

FBR Capital downgraded Cisco (NASDAQ: CSCO) from Market Perform to Underperform with a price target of $17.00 (from $22.00) saying routers and switches hit a dead end.

“We believe Cisco will become increasingly more challenged to offset weaker-than-expected routing and switching demand as it works to transition to a more software- and service-centric business model,” the analyst said in its downgrade report. “Looking ahead, we see the potential for additional negative technological trends that could significantly blur the lines between routers, switches AND servers.”

Now I don’t know anything about the track record of FBR Capital. It’d be bolstering if we had any idea how their opinions translate into long-term results, but we don’t have that.

What we have is a threat to profitability at CSCO. We could nutshell and capture this question with a potentially-similar situation from a few years ago. A number of community members at the time cautioned us to avoid the rosy consensus at one of our favorite companies. They urged us to consider reality. We ignored them (a little) at our own peril.

The company was Garmin (GRMN). The warnings had to do with a ubiquitous threat to their business model at the time. It was, in perfect hindsight — a clear and present danger. [Ed. Note: GRMN has navigated (pun intended) the choppy waters of these challenges pretty well, but it was a speed bump of considerable impact.]

So the question is: Is Cisco Systems exposed to the same type of threat to product, inventories, profitability AND STOCK PRICE as we saw with Garmin?

I don’t know.

So I turned to a very reliable research partner, our own Technology Manager, Kurt Kowitz. Kurt has a powerful skill of boiling this type of thing down into something concrete and credible. (By the way, Kurt and Hugh McManus were among the throng issuing the warning about the challenges faced at Garmin back in 2007-2008.)

As he always does, he responded with: It really boils down to one phrase/theme, Software-Defined Networking. “Companies Google and Facebook have adopted the Openflow protocol within their data center operations.” Ouch. “Yeah, sounds like a shift that might seriously undercut a traditional market.”

So it’s back to Cisco Systems. And now we’re gleaning through the most recent quarterly conference call transcript looking for signs of things related to (1) threats to forward profitability and/or (2) anything specific about this software-defined networking.

And we find a brief discussion relevant to the subject in the form of a “disciplinary lecture” given by the horse’s mouth itself, John Chambers:

“If you watch, we’re seeing a common theme, I think many of you [rhinos] were concerned in fair question two years ago about should we maintain our gross margins with the vast majority of the markets not a player, and you’re going to see rapid deterioration, it was the number one pressure on our stock margins. And if you watch what we have done is the reverse.’

Our emphasis added: We’ve prevailed, actually increased margins despite what you believed would probably happen. (Go back and review the accompanying profitability analysis graphic.)

Chambers continued:

“We have gotten very good stability across the gross margin base, you are seeing this in that 61% to 62% guidance, it will go up and down by quarter based on the mix, but you are right we are clearly modeling in continuing good growth dramatically faster in our data center business, and remember UCS is also combined with Nexus. And it is a process I want to be careful but you see it is a little bit lower half of the business Nexus, is a little bit over a third, and when you model those two together you begin to get good gross margins and that’s different than our peers.”

(He often jabs and picks on peers, nothing new to see here, people.)

“Secondly, and most of our peers when they install servers, they are selling commodity products. Have we re not selling commodity products. We get premiums, we get architectures, we get standardized on, we showed stronger margins there and yes your overall assumption is right, we are moving rapidly to software … which gets you better margins, 13 of the 14 acquisitions were software, cloud, recurring revenue streams and recurring revenue as one of your colleague said earlier, the good news about it is very predictable. The bad news is when you start from a low base, it takes you a while to get to size where it really becomes material for you, but it’s a nice way of saying I couldn’t be more pleased with the margin stability and well, it’s hard to look out very far in this industry, I like the stability we are seeing in and I see nothing that at the present time is making nervous on that …”

How much cash do they have (for further acquisitions and development?)  Answer: $46.4 billion (1/26/2013) [Source: Value Line]

The Bigger Picture

CSCO has the cash and the track record. They’re actively responding to the challenge.

If you hold CSCO, be vigilant for slippage in profitability. Be aware that the global recession will certainly lead to some weakness as the worldwide economy cycles.

Here’s a slightly elongated look at one of our newly favored 10-year charts, displaying the 1990s. If you were there, you remember the 1990s. This again shows how resilient an excellent company can be in the aftermath of a corrective disruption. By the way, that 1998 contagion thing was more massive than very many of us remember. Most of us were too busy being rationally exuberant at the time.

And we close with a current chronicle going back a few years for Cisco Systems (CSCO).

The quality ranking is virtually top shelf with no signs of weakness. If profitability slips (vs. peers/competitors) the deterioration will show up in the quality ranking.

The return forecast is not exciting — equivalent to a fairly solid “HOLD” for most portfolios at approximately 11-12%. And we also see that patience can be rewarded with a return forecast closer to 20% from time-to-time. The time to accumulate would be then.

For Cisco Systems (CSCO):  Watch carefully. Wonder. Wait.

Value Line Low Total Return Screen (3/22/2013)


Companies of Interest

The average low total return forecast for Issue 5 is 7.0% — so there are some shopping opportunities in the group. (Reminder: The companies displayed in the screening results are limited to the top two quality ranking quintiles, or greater than 60)

Nu Skin (NUS) is a somewhat speculative study but displays some promising characteristics. I’m reminded of Laura Berkowitz’s timeless “Confessions of a SafeSkin Buyer” published years ago in Better Investing and wonder if the study shouldn’t include a threats and opportunities analysis of single-product companies, fads … and the like.

Gentex (GNTX) is a potential study in conflicted consensus. Morningstar thinks the price-to-fair value ratio for GNTX is 74% (attractive). S&P thinks the P/FV is 103% (fairly/fully valued). Go ahead. Rumble. What do you think?

Walgreen (WAG) and CVS Caremark (CVS) continue their leadership campaign and compete with each other. Both companies remain attractive from a return perspective and the fundamentals at CVS have strengthened of late — now topping WAG in the quality ranking. S&P sees opportunity with a P/FV of 74% for CVS.

Materially Stronger: Arris Group (ARRS), Cisco Systems (CSCO)

Materially Weaker: Acme Packet (APKT), Broadcom (BRCM), Tellabs (TLAB), Alaska Communications (ALSK)

Market Barometers

The Value Line median low total return forecast is 6.8%, down slightly from last week’s 6.9%.

VL Low Total Return Screen (12/21/2012)

Why do we pay attention to the Value Line weekly updates? Because a number of highly successful long-term investors cite Value Line as one of their favorite trusted resources.

“I don’t know of any other system that’s as good… The snapshot it presents is an enormously efficient way for us to garner information about various businesses… I have yet to see a better way, including fooling around on the internet, that gives me the information as quickly.” — Warren Buffett, Berkshire Hathaway, 1998 Annual Meeting speaking about The Value Line Investment Survey.

“[Value Line is]…the next best thing to having your own private securities analyst.”
—Peter Lynch, One Up On Wall Street

In our case, we’ve found the low total return forecasts for all companies to be among the most compelling opinions/forecasts while we either (1) search for opportunities or (2) practice effective stewardship when it comes to staying vigilant about our current holdings.

Materially Stronger: None

Materially Weaker: Neutral Tandem (IQNT), NII Holdings (NIHD), Marvell Tech (MRVL), Adtran (ADTN), Rite Aid (RAD), Cisco Systems (CSCO), F5 Networks (FFIV), Regis (RGS)

Point-and-Figure (PnF) Trend Source: