'Dogs of Dow' Have Subpar Year, Thanks to Citibank
A contrarian investment strategy known as "Dogs of the Dow" has been a laggard this year, pulled down by Citigroup, one of the biggest casualties of the subprime credit meltdown.
The strategy involves buying the 10-highest yielding stocks in the Dow Jones Industrial Average, with an equal amount invested in each, and holding them for one year.
Over the long haul the strategy has beat the 30-stock Dow Jones Industrial Average with help from the high yields and the ability of long-established companies to bounce back from temporary problems.
"Citigroup did not help the portfolio at all this year," said Neil Hennessy, president and portfolio manager of Hennessy Advisors Inc in Novato, California.
Citigroup's shares have lost about 47 percent in 2007 as write-offs hurt earnings and brokers downgraded the stock.
Hennessy notes that General Motors has also been a disappointment this year, losing 16 percent.
Based on their current yields, both Citigroup and GM are certain to stay Dogs when the strategy is re-balanced at the end of the year.
In fact, only one substitution is likely at the start of 2008. After a 35 percent rise in 2007, Merck is yielding about 2.6 percent and no longer makes the cut based on yield. Home Depot , which fell about 34 percent, is now yielding over 3 percent and seems a safe bet to replace Merck in the Dogs.
As a stock price falls, the yield rises, and a higher stock price results in a lower yielder.
There is always the question of whether a company with a high yield will cut its dividend as it shores up its capital base. There has been considerable discussion in the market that Citigroup, with a 7.3 percent yield, is a candidate.
"They say they're not going to cut it so you have to take them at their word," Hennessy said. Still, he said, all of the talk makes it easier for the board to make a decision to cut.
Even if Citi halved its dividend, it would still have a chance to remain in the Dogs.
Hennessy, whose firm offers two mutual funds based on the strategy, concedes the strategy has its critics. Both of his funds are up about 3 percent so far this year.
Some have called the Dogs strategy gimmicky. It can also be faulted for its limited diversification. Sometimes, a company in the Dogs will be a drag on performance for a long time as its problems defy a quick solution.
"This is for the long term, Hennessy counters. "It isn't for people who want to get rich overnight."
The Dogs strategy, as measured by the Dow Jones High Yield Select 10 Total Return Index has returned about 3 percent this year, including reinvested dividends. By the same total return calculation, the Dow Jones Industrials are up nearly 10 percent.
In 2006, the strategy had an exceptionally good year, returning about 30 percent, far more than the Dow industrials.
In addition to 2006, The Dogs beat the Dow industrials on a total return basis in the years from 2000 to 2002, although by virtue of having a smaller loss in two of those years. The returns of the Dogs and the Dow 30 were a near dead heat in 2003. The Dow beat the Dogs in 2004 and 2005.
According to the dogsofthedow.com Web site, over 15 years ending in 2006, the Dogs and the Dow 30 have each posted average annual returns of about 13 percent, with the Dogs having a small edge.
"Like everything else, some years it works and some years it doesn't," said Hugh Johnson, chief investment officer of Johnson Illington Advisors, in Albany, New York. "My suspicion is that it is going to work very well in 2008."
Johnson said financial stocks and cyclical stocks, which are sensitive to the economy, are likely to bounce back in the new year.
One reason for the disparity between the Dogs and the Dow Industrials this year is that Dow component stocks like Honeywell International , Intel and McDonald all have gained around 35 percent this year. None was in the Dogs because of their modest yields.
Hennessy noted that telecoms AT&T and Verizon Communications have been part of the Dogs and contributed to the returns this year with dividends of around 4 percent and price gains of around 19 percent and 20 percent respectively.
Another of the Dogs, General Electric, has delivered a flat stock performance this year, but it's dividend exceeds 3 percent.
GE recently announced an 11 percent increase in the dividend, its 32nd consecutive annual increase. Hennessy says he is confident the stock will be doing better at some point.
More of a pure play on the Dogs strategy is available in an exchange-traded note recently launched by Deutsche bank AG. The ELEMENTS Dogs of the Dow ETN seeks to track the Dow Jones High Yield Select 10 Total Return Index.
Money manager Michael O'Higgins of O'Higgins Asset Management Inc in Miami Beach is credited with creating the Dogs of the Dow. He outlined the strategy in a 1991 book "Beating the Dow."