When the ‘dogs’ have their day you will make some money too

When the ‘dogs’ have their day you will make some money too

It may sound like someone selling magic pendants but there is one investment strategy called “Dogs of the Dow", which does have some quality to invite both praise and ridicule.

Johnny: Without ridiculing the dogs living in my neighbourhood, can you tell me what “Dogs of the Dow" means?

Jinny: “Dogs of the Dow" is an investment strategy that has become popular due to its simple approach for generating a return better than that of a market index. The theory was made popular by Michael O’Higgins and John Downes in their book Beating the Dow, published in 1991. Ever since then, almost every dog on Wall Street has believed in its own worth.

“Dow" here refers to the Dow Jones Industrial Average, which is a market index of 30 significant stocks traded on the New York Stock Exchange and Nasdaq. The term “dogs" refers to 10 Dow stocks currently offering higher dividend yield compared with the rest. The “Dogs of the Dow" theory merely implies that the 10 stocks offering the highest dividend yield may actually be undervalued compared with other stocks constituting the index. This strategy involves picking up “dogs" that are temporarily lying low.

Johnny: I don’t understand what dividend yield has to do with valuation of a stock. Can you give more details?

Jinny: Dividend yield, as you may be aware, is expressed as a percentage of the amount of money paid as dividend in terms of the current market price of the stock. If stock A is paying you a dividend of Rs10 at the current market price of Rs100, then the dividend yield is 10%. If the dividend yield rises to 20%, then either of two things might have happened: The company might have increased the amount of dividend from Rs10 to Rs20 while the share price continued to be the same or the share price might have decreased from Rs100 to Rs50 while the amount paid as dividend remained the same. It is also possible that the company raised the dividend by some amount but the share price decreased by a certain amount, resulting in a dividend yield of 20%.

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The “Dogs of the Dow" theory believes that the amount of dividend remains constant for a longer time and most of the correction in the yield takes place due to the rise in the current price of the share. A company offering the highest dividend yield has the most chance to see a price rise over a period of time which would revert its dividend yield to the overall market average.

Johnny: Well, you sound like someone who takes yields very seriously. Tell me, how can we put the “Dogs of the Dow" theory into practice?

Jinny: It’s pretty straightforward. You pick up in equal proportion 10 stocks currently offering the highest dividend yield out of the 30 stocks in the Dow or any other stock index, for that matter, and hold your investment for a year. After one year, you need to again review your portfolio. Some of your stocks might have gone out of your list and some new stock might have made an entry. You have to sell the stocks that have gone out and buy the ones that have come in. Keep the stocks that are still there in the list and repeat the whole process once again the next year.

In this manner, you would be buying the stocks that are currently undervalued and selling the stocks that have recovered their value. This is how you make money.

O’Higgins tested this hypothesis by analysing the data for a 17-year period from 1973 to 1989, which showed that the strategy on an average generated a return of 17.9% annually compared with 11.1% return for the Dow. Surely, a very impressive strategy if you look back.

But good performance in the past doesn’t mean that the strategy would continue to work well in the future. The most recent performance of the “dogs" does not seem that impressive. In both 2007 and 2008, the “dogs" underperformed the Dow.

Johnny: This happens in the life of every dog. After all, you never know when a dog might have his day.

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What:“Dogs of the Dow" is an investment strategy that has become popular due to its simple approach for generating higher return.

How: “Dogs of the Dow" strategy recommends purchasing 10 stocks of an index that have the highest dividend yield and rebalancing the portfolio after a year.

Who: The strategy was made popular by Michael Higgins and John Downes in their book titled ‘Beating the Dow’.

Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at realsimple@livemint.com.

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