Very few stock indices represent the power and fortune of Wall Street quite like the Dow Jones Industrial Average. First calculated more than 120 years ago, the Dow is considered an important barometer of the U.S. equities market.
The Dow is a price-weighted measure of 30 U.S. blue-chip companies, covering all industries except transportation and utilities. Although stock selection is not governed by strict quantitative rules, the companies selected for inclusion in the Dow must have a strong reputation and demonstrate sustained growth. The stock picks must also be of prime interest to investors. Interestingly, all 30 companies listed under the blue-chip index are dividend payers.
Click here for a complete list of the Dow 30 dividend stocks.
The Dogs of the Dow Strategy
While the Dow is a mainstay of many indexing strategies, it can also point investors to promising individual stocks within its ranks. After all, if a stock is good enough to be listed in the Dow, it’s potentially a great addition to an income portfolio.
There are many strategies for investing in Dow 30 stocks. One of the most intriguing is the so-called ‘Dogs of the Dow’ strategy, which was first popularized in 1991 by renowned money manager Michael O’Higgins.
The Dogs of the Dow strategy tells investors to invest annually in the ten Dow components whose dividend is the highest fraction of their price. In other words, you pick the ten Dow companies with the highest dividend yield. You would then reshuffle this portfolio annually to maintain equal exposure to the top-ten dividend performers.
This strategy is really as simple as it sounds, and only requires an annual review to reassesses the Dow 30 on the basis of their dividend performance.
One of the main assumptions of this strategy is that the Dow laggards are still very good companies. Despite temporarily falling out of favor with investors, they generally return to health as markets revalue them properly. This gives investors the opportunity to consistently replenish their portfolios with other good companies that were previously disavowed due to cyclical markets or other temporary factors.
The great thing about the Dow is that it is made up of Wall Street’s biggest and most prestigious firms. Components that can be had for cheap and sold at more favorable prices later on provide good investment opportunities for yield-seeking investors.
In theory, high dividend yields should signify that a stock is undervalued, and undervalued Dow components are normally due for a strong rebound. Even if the stock performs modestly, investors can still benefit from the high yield.
The committee involved in selecting stocks for inclusion in the Dow is only concerned with picking the most highly valued and well-established companies. That means if a company truly falls out of favor, it will be replaced by another company with stronger value prospects. This steady shuffling has been part and parcel of the Dow’s selection process for over a century. This is why the Dogs of the Dow method has proven so successful for the past three decades.
Find out more about the Dow 30 stocks here.
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Typically, the low-maintenance strategy espoused by the Dogs of the Dow pays off. Between 1957 and 2003, high-yielding stocks have outperformed the Dow 30 with an annual return of 14.3% versus the benchmark’s 11% gain.
However, the Dow’s most generous dividend payers of 2016 have struggled to keep pace with their non-canine peers this year. They’ve also lagged behind the broader Dow Jones index. This is partly because high dividend stocks are sensitive to higher interest rates. The Federal Reserve has raised interest rates three times since December and is expected to continue normalizing monetary policy for the foreseeable future.
The so-called Small Dogs of the Dow – the five cheapest high dividend stocks – are also having a tough time replicating past success. They too have underperformed the non-canine stocks as well as the broader Dow average. However, going back to 2000, the small dogs have outperformed their larger peers.
Use the Dividend Screener to find high-quality dividend stocks. You can even screen stocks with DARS ratings above a certain threshold.
The Bottom Line
The Dogs of the Dow strategy provides a compelling argument for income investors looking to leverage the full potential of the blue-chip index. As history has demonstrated, it’s a low-risk, high-reward strategy that can help investors capitalize on market downturns.
Want to know how Dow 30 stocks reacted in times of major events? Click here for more.