Impact of DJIA’s change on Dogs of the Dow strategy

Feb.13, 2008 in Market Outlook

The Dow’s dogs

Commentary: Changes to the DJIA will affect Dogs of the Dow strategy

By Mark Hulbert, MarketWatch

Last Update: 10:57 PM ET Feb 12, 2008

ANNANDALE, Va. (MarketWatch) — What impact will upcoming changes to the DJIA
have on followers of the Dogs of the Dow strategy?

The Dogs of the Dow, of course, refers to the stock-picking strategy that invests
in those stocks within the 30 in the Dow Jones Industrial Average ($INDU) with
the highest dividend yields. These stocks are often referred to as “dogs” because
high-yielding stocks tend to be those that are out of favor.

In its original and simplest form, the Dogs of the Dow strategy calls for buying
the 10 highest-yielding stocks. Numerous variations have been suggested over the
years, such as buying the five lowest-priced of the 10 highest yielding stocks -
or even a single-stock strategy, known as the Penultimate Profit Prospect, which
calls for buying the second-lowest priced stock among the DJIA’s 10 highest
yielders.

The changes to the DJIA that were announced on Monday affect several versions of
this strategy because one of the stocks being deleted was a “dog,” and so is one
of the stocks being added.

The deleted dog is Altria Group Inc. (MO), which currently is the fifth highest
yielding stock in the DJIA. Of the two stocks that will be added to this average
later this month, the one that will be a Dow dog is Bank of America Corp. (BAC);
with a current yield of 5.95%. Once the change is made, and assuming that
relative yields don’t change in the interim, BAC will be the highest yielding
stock in the DJIA.

The implicit bet that underlies the Dogs of the Dow strategy, of course, is that
the yields of the highest-yielding DJIA stocks will decline as their prices go
up. But, needless to say, price appreciation isn’t the only way in which a yield
can decline: Another is for the dividend to be cut.

This latter possibility is especially worth bearing in mind when considering the
stock of Bank of America, since this is exactly what happened to the other bank
that is already part of the DJIA: Citigroup, Inc. (C). Its stock was far and away
the highest yielding DJIA stock at the beginning of the year, with a yield of
7.3%. Its yield has indeed come down since then, of course — but not primarily
because of price appreciation: In the wake of huge losses precipitated by the
subprime mortgage mess, the bank cut its dividend in January.

Interestingly, however, Citigroup remains a Dow dog even after its dividend cut.
It currently is the second highest yielding DJIA stock, and will be in third
place after Bank of America is added (again assuming no other changes in the
interim).

To reduce the possibility that a high yielding stock will cut its dividend, some
advisers focus on the dividend yields of just those stocks with high credit
ratings. This in fact is the approach taken by the newsletter on the Hulbert
Financial Digest monitored list with the third best risk-adjusted performance
over the past 20 years: Investment Quality Trends, edited by Kelly Wright. (The
newsletter was founded by Geraldine Weiss several decades ago.)

To be sure, this approach isn’t foolproof. Citigroup had an S&P quality ranking
of “A+” at the end of last year, but that wasn’t enough to prevent the dividend
cut. Nevertheless, the approach has powered Investment Quality Trends to a far
superior long-term record than that of newsletters which exploit high-yield
stocks by using the Dogs of the Dow strategy.

Wright adds an additional twist when focusing on dividend yield: Rather than
comparing a company’s yield with those of other companies, he compares it to the
historical range of that company’s yield. He will recommend a company for
purchase if its current yield is high relative to that range, even when its yield
may be lower than another company’s. Likewise, he will avoid a company with a
high yield if that yield is not at the high end of the company’s historical range
– even when its yield may nevertheless be higher than other companies.

Not surprisingly, Wright’s approach to dividend yield leads to a significantly
different buy list than what one would come up with when focusing on raw dividend
yield alone. Of the 10 current Dow dogs, for example, only four are deemed
undervalued by Wright’s approach: Citigroup, General Electric Co. (GE), Merck &
Co. Inc. (MRK), Pfizer Inc. (PFE).

Bank of America stock, which will become a Dow dog on Feb. 19, is also considered
undervalued by Wright’s approach.

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