Dogs of the Dow for 2009
It's time to pick from the pack, but with companies cutting dividends, do the old dogs need to learn some new tricks?
NEW YORK (Fortune) -- If you invested in the Dogs of the Dow last year, you had one dog of a time. The stocks failed to outpace the S&P 500 or the Dow 30 (both of which had a miserable year), but that doesn't mean you should give up on them, says the man who popularized the investing strategy.
"You have many years where you don't do well with it," says Michael O'Higgins, who runs O'Higgins Asset Management, "and those are generally the times when you should stay with it," because usually in the following years it comes running back.
O'Higgins, who started his firm in 1978 and has $30 million in assets under management, popularized the strategy more than 35 years ago. It's simple: You invest in the 10 stocks in the Dow 30 that have the highest dividend yields after the market closes on the last day of the year (to calculate the yield, divide the annual dividend payout by the stock price). Hold them for a year, and rebalance.
They're called dogs, because their prices have dropped precipitously. But since they pay a steady dividend, followers of the strategy believe the blue-chip companies are still confident in their futures and have strong fundamentals, while the stocks may be oversold and are ready for a rebound.
"You're investing in some of the largest companies in the world," O'Higgins says, "and you're buying them when they're down on their luck."
The Dogs finished 2008 down 38%, according to O'Higgins. The Dow fell about 32% and the S&P 500 dropped about 37%. Since he started following the strategy at the end of 1972, O'Higgins says the Dogs have averaged 12.6% a year until the end of 2008, beating the Dow (about 10%) and the S&P (about 9%).
A twist on the theme is the "Flying Five," or the five lowest-priced stocks of the Dogs, based on the theory that the lower the price, the greater the swing, but that can go in both directions. The Five averaged returns of 14.3% a year from the end of 1972 to the end of 2008, according to O'Higgins's data.
The Dogs of 2009, selected at the beginning of the year, include:
- Alcoa (AA, Fortune 500)
- AT&T (T, Fortune 500)
- Bank of America (BAC, Fortune 500)
- DuPont (DD, Fortune 500)
- General Electric (GE, Fortune 500)
- JPMorgan Chase (JPM, Fortune 500)
- Kraft (KFT, Fortune 500)
- Merck (MRK, Fortune 500)
- Pfizer (PFE, Fortune 500)
- Verizon (VZ, Fortune 500)
It's a diversified group with some of the biggest companies in their respective sectors, which O'Higgins likes. All were returns from the 2008 Dogs except Bank of America, Kraft, Merck, and Alcoa.
O'Higgins is not about to predict how the Dogs will fare this year. The S&P and Dow might have beaten them in 2008, but there have been several years when the market goes down and the Dogs see a tidy rise. In 2000, for example, the Dow was down about 4.5% and the 10 stocks were up 5.6%.
But some think the dogs have had their day.
"It's a methodology that has worked, but this year is different," says Howard Silverblatt, senior index analyst with Standard and Poor's. "It's a very difficult year for dividend investors, and they really have to look to the individual issue to see what their business is."
Up until now, the strategy was a good starting point for investors, he says. But today the markets are too destructive. Silverblatt believes companies are paying more than they should, and they may not be able to cover their dividends this year. Instead, he says, they should be conserving cash.
"There are no sacred cows anymore," according to Silverblatt. "The old formulas do not work in the current environment. They need to be amended and adjusted."
Investors may want to broaden their approach. He suggests picking companies that have enough money to not only cover their dividends but also have a cushion.
Silverblatt expects dividend cuts in the year ahead. Two of the Dogs, Bank of America and Pfizer, have already reduced their payouts. Companies under stress are obviously not increasing their dividends. But those that tend to increase their dividend every two to four years - basing their investor payout on cash flow, earnings, and the actions of their peers - will probably hold steady, he says.
When O'Higgins first started using the strategy, his portfolio strictly followed the Dogs, but now he has about a quarter of his money in them. Looking for a higher payout, he currently thinks precious metals are a good bet; he has a large position in gold mining stocks and is looking at emphasizing more platinum, palladium, and silver.
But for the average investor, O'Higgins thinks the Dogs are still the best way to go. They've outperformed, they require little time, and they're safe, he says. Simplicity is a large part of its appeal, which was one of O'Higgins's intentions.
In 1972 he was a stockbroker on Wall Street, but he found that there was too much information out there to manage, and a lot of it was wrong. For the everyday investor, relying on the Dogs made the complexity of the marketplace less overwhelming.
"In order to have a chance of beating guys like me, they have to spend a lot of time doing it," he says. "That time - given the amount of money that they're managing - is better spent in their own career doing what they do and doing that better so they have more money to invest." 
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