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%.

Source: www.dogsofthedow.com

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 www.stockcharts.com 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 www.morningstar.com 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.