Spot the Dog

19th May 2010

There are some obvious investment ideas out there.

Then there are the less obvious ones –  and then there are the ones that are completely barking.

Rather strangely, the one that barks the loudest of all is one of the more likely ones to make you rich.

We are, of course, talking about the Dogs of the Dow – an investment theory that's been around since 1991, when a certain Michael O'Higgins published a book that advocated buying the ten highest-yielding shares in the Dow Jones DJ-30 index every January, on the expectation that they would outperform the market in the next twelve months.

Then, the following January, you'd simply sell any of the Dogs that didn't make it into the top ten yielders' list any more, and replace them with the ones that did.

According to Mr O'Higgins, his strategy would have beaten the Dow by an average of 6% a year during the late 1970s and 1980s.

Which would have made you, ummm, very wealthy indeed.

No sign of trouble?

Now, I'll admit this seems a pretty weird concept.

Normally, a company that's paying an unusually large dividend is sending out a signal that it's in trouble.

Under normal circumstances the City will always have a rough idea as to what sort of dividends a typical company in a typical investment sector ought to be paying, and so it'll tend to use the divi as one of the marker buoys when it's deciding where to set the share price.

Any company that stands out by having a much bigger dividend than the rest is probably having to try too hard to keep its shareholders happy, and to stop them from running away.

And that's bad, surely?

Well, yes it is. If you looked at the highest yielding companies on the London Stock Exchange, you'd probably find that they all fell into two categories.

Either they were deadbeat companies in areas like chemicals, or banking, where the long-term prospects for capital growth were pretty limited, and where a big dividend was the only way of keeping investors interested.

Or else they were genuinely on the ropes. When a share price has fallen really low, really fast, even an average-sized cash dividend can look like a great big yield by the time you've divided it into its shrunken share price. (That's the normal way that dividend yields are calculated.)

There have been times in the last decade when fast-failing companies like Woolworths or Marconi have been delivering dividend yields of 50% or more because their share prices were such rubbish.

And yes, they've all failed completely since then.

Solid blue chips

This just seems to be getting worse, doesn't it? But relax, because the Dogs of the Dow idea isn't asking you to put your money into small or even medium-sized companies.

The Dow Jones consists of just 30 very large companies which completely dominate the US business scene – the likes of Microsoft, Pfizer and Coca-Cola.

The Dogs are all solid blue chip companies, and they're not likely to go down the tubes in the space of one calendar year.

 In 2010, for instance, the Dogs are Verizon and  AT&T, the communications companies, both at around 6.5%; the pharmaceuticals giants Merck, Dupont and Pfizer, all around 4.5%;  and Kraft, Chevron Oil, Boeing, Home Depot and McDonald's, all in the 3% to 4% band.

These are emphatically not small companies.

The 2009 Dogs included Bank of America, JP Morgan Chase, General Electric and the mining company Alcoa instead of the last four.

And yes, they were all in trouble…..

Between them, the Dogs are currently paying more than twice as much dividend as the 1.9% average yield that you can currently get on Wall Street.

That's another way of saying that, if those companies' circumstances were ever to revert to normal, you might be in with a statistical chance of a 100%-plus gain.

That's what would happen once the stock market's self-levelling calculations kicked in and the share prices adjusted themselves upward to take account of the high cash value of the dividend.

But all this, of course, is making the big assumption that those companies really can restore their market credibility.

In truth, some will carry on struggling and some will fail completely.

Still, if you can handle the risk, the Dogs of the Dow idea has quite a lot going for it.

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