The "dogs of the Dow" investment strategy has been around for more than 20 years, and it still works. The strategy automatically selects the most undervalued stocks -- the dogs -- of the Dow Jones Industrial Average index, and it replaces them when different stocks in the index meet the dog criteria.
History of Dog Theory
The dogs of the Dow strategy was developed and described by money manager Michael O'Higgins in his book "Beating the Dow." O'Higgins' book was published in 1991, and the dogs of the Dow strategy has been popular ever since. The Dow Jones Industrial Average -- DJIA -- is the oldest and most widely followed U.S. stock market index. The dogs strategy provides a simple way to consistently beat returns from this famous index.
Picking the Dogs
In the dogs strategy, the stocks selected from the DJIA are the 10 with the highest dividend yields as reported at the end of the year. All 30 companies in the Dow Jones Industrial Average are large and stable, so the reasoning is that those with the highest dividend yields are undervalued in respect to the overall average.
An investor implements the dogs of the Dow strategy by purchasing an equal dollar amount of the 10 dog stocks on the first of the year and holding those stocks for one full year. For the next year, a new list of dogs is determined, and the 10 stocks are rebalanced or replaced. For example, at the start of 2012, McDonald's and Chevron dropped out of the list of highest-yield stocks, and General Electric and Procter & Gamble were added.
For the 10 years ending Dec. 31, 2011, the dogs of the Dow strategy produced an annual return of 6.7 percent, including dividends. In comparison, the DJIA returned 6.1 percent per year, and the S&P 500 averaged 5.0 percent. For the 20-year period through 2011, the dogs strategy produced a 10.8 percent average annual return. That matched the DJIA, and it beat the S&P 500 by 1.2 percentage points.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.