Dividends are the hidden jewel of the investment world. These often-overlooked treats have been the backbone of great stock market returns for the better part of a century. The returns dividends generate, when reinvested, have given us most of the big compounded numbers you see on the glossy sales briefs at the local brokerage houses. One well-known and successful strategy for cashing in on this dividend phenomenon has garnered both praise and ridicule.

That famously simple investment strategy is known as the Dogs of the Dow, or the "Dow dividend strategy," and has earned its reputation by being a simple and effective way to beat the market over time. It involves owning the 10 highest yielding stocks of the Dow Jones Industrial Average (DJIA), rebalanced every New Year's Eve. Saves time, saves effort - less filling, tastes great. Well, maybe, but we'll get to that.

In the tutorial, "Stock-Picking Strategies: Dogs of the Dow," we mentioned that, "from 1957 to 2003, the Dogs outperformed the Dow by about 3%, averaging a return rate of 14.3% annually, whereas the Dow averaged 11%." More recently, 2011 saw the Dow Dogs averaging 8.3% while the Dow Jones performed at just 3.3%. While this record is impressive enough, the reasoning behind its success is why you should consider employing this strategy.

The Strategy
Views differ on the Dow dividend strategy. They all seem to agree that this strategy outperforms the market, but they don't agree on why. Is it logical reasons or just plain luck that generated those returns? Many people argue that the Dogs of the Dow strategy does have merit because it is fundamentally based. The Dow dividend strategy is simply a way to pick one-third of the Dow stocks, which, using their relative yields as value indicators, are more likely to be discounted than their Dow brethren.

Discounted stocks can be viewed in a few different ways. Firstly, there is no difference in relative value among these and the other Dow stocks. This idea is that the market has valued all stocks correctly, including the high-yield stocks. However, the difference in return is only the higher average dividend yield between the Dogs and the others. If this difference is 3% on average, then that might be explained by the higher yield on the Dogs. Many assume that the market corrects stock prices for dividend payouts. In the daily movements, maybe it does, but over months and years, many would argue that this may not be the case. Instead, the market often values companies based on current and expected earnings, with little attention to whether or not those earnings are paid out in the form of dividends.

Secondly, the Dogs have been, well, dogs - they have been pushed down in price by the market, which sends their yields up. Assuming that, as a group, the Dogs aren't much better or worse companies than those in the rest of the Dow, this idea may have some merit. Benjamin Graham, in his classic book "The Intelligent Investor" (1949), wrote that large companies almost never go broke; they have some periods of success and other times they struggle. The Dow dividend strategy is by no means an in-depth fundamental analysis, but it can be a useful indicator to help find those large, struggling (read: cheap) companies of which Graham spoke, and to buy them when they're struggling, just before they embark on their periods of success.

This leads us to the main problem with the Dogs strategy. Yield as a valuation metric is much too simple to be useful in telling us what a company is actually worth. The Dow dividend strategy is lead by the indicator of yield, which is not a true valuation metric unto itself, such as P/E, price-to-book or free cash flow numbers.

After all, dividends are easily changed, unlike earnings or book values, and most companies in the Dow could change their dividends (and yield) within a 10 minute meeting by the boards of directors. In other words, successful companies could start paying out huge annual dividend yields to become Dogs, or poor performers could cut their dividends and avoid being relegated to the dog house. However, this rarely happens and the dividend policy of Dow stocks is usually held to the tradition of moderate dividend growth as the earnings grow. In general, companies never cut their dividends unless they are really suffering. That said, the yield, as compared to other Dow stocks, can show which companies' shares have fallen behind and are due for a rebound.

Being a Dog Owner
If you want Dogs, here are a few owners' tips to keep in mind.

  • You will own some Dogs, so just get used to it. If you can't, buy an index fund - some people just shouldn't own individual stocks. The losses in individual stocks can drive some investors nuts.
  • There are no guarantees. This might sound crazy, but there is no guarantee that this strategy will work in the future. Therefore, it may be better to hedge your bets, and simply use it as another weapon in your arsenal than to bet the farm on this one strategy. Ten to 15% of your portfolio makes sense here.
  • Always reinvest the dividends. If you want the to beat the market, use those quarterly dividend checks to buy more shares. This trick isn't figured into those returns you saw, but would boost those numbers nicely.
  • This strategy is not short-term. If you want to beat the market, it's much easier if you can employ the one emotion that the market doesn't usually show: patience.
  • Avoid over-emphasizing recent returns and deemphasizing earlier returns when choosing investments. It's just human nature to do this, but just when it looks like a strategy doesn't work anymore, that's when it can surprise with the best returns. For instance, look at the ridicule Warren Buffett's non-tech strategy got in the dotcom era. The market beat down his share price, while loading up on tech stocks. Well, as we've seen, that was a big mistake.

    The Bottom Line
    The Dogs may not be the most advanced strategy in the world, but if you can add it to the rest of what you do, it could give you a few extra dollars. Remember though, that the market historically has gone down about a third of the time, and up about two-thirds. Don't expect the Dogs of the Dow to be any different. If you're going to be in the market, you have to get used to this fact of a Dog's life.