AAII Stock Ideas: Dogs of the Dow Strategy Screen

Today, I cover a strategy that focuses exclusively on blue-chip companies and purchasing them when they become undervalued relative to each other. Dogs of the Dow is a disciplined approach for individuals seeking value-oriented, large-cap stocks and a steady source of dividend income. Read on to learn how to use the AAII Dogs of the Dow screen and see lists of companies meeting the criteria.

Dogs of the Dow: A Contrarian High-Yield Approach

The Dogs of the Dow is a simple and purely mechanical approach that calls for an investor to buy the 10 highest-yielding stocks in the Dow Jones industrial average at the start of every calendar year. An equal dollar amount is allocated to each of those 10 stocks and the portfolio is held for 12 months. On the first trading day of the next calendar year, the process is repeated, and the portfolio is reconstructed with the newest highest yielders.

Table 1 highlights the 10 companies that passed the Dogs of the Dow screen as of December 31, 2019. To conduct a midyear checkup, AAII looked at these 10 companies passing the screen at the end of last year and updated the financial information and year-to-date performance through June 30, 2020.

Table 1. Companies Passing Dogs of the Dow on 12/31/2019: 10 Highest Yielders and Low Priced 5 Screen (Ranked by Stock Price, Low to High)

The theory behind Dogs of the Dow is that a high yield implies that a stock is undervalued relative to the other Dow stocks. Investors seek to purchase often supposedly out-of-favor, high-yielding stocks whose relative yields suggest that their valuations are underpriced. This is not always the case, as a stock could have a high yield and trade at high multiples of both earnings and book value.

According to the Dogs of the Dow approach, identifying undervalued Dow stocks is most effectively done by examining the dividend yield — a company’s total dividends expected to be paid over the next 12 months divided by current share price.

If a stock’s price rises faster than its dividend, the yield may be low, indicating that the price may have been bid up too far and may be ready for a decline. Conversely, if the dividend yield is too high, the stock may be poised for an increase in price, if the dividend can be sustained. Yield can increase if either the stock price falls or the company raises its dividend payment. Obviously, the latter is always preferable.

While stocks pass the Dogs of the Dow screen because of their high current dividend yield relative to other Dow stocks, a study of the company’s historical dividend yield can be equally revealing. A current dividend yield that is higher than its historical average would be a sign that a stock is potentially undervalued.

Cisco Systems Inc. (CSCO) — an American multinational technology conglomerate engaged in designing and selling a range of technologies across networking, security, collaboration, applications and the cloud — was the top performer from the Dogs of the Dow list for 2020 through June 30. Cisco benefits from long-term trends such as a rapid rise in bandwidth consumption, high-demand data center solutions and migration to cloud networking. In the near term, the company faces some challenges as infrastructure platforms will likely continue being weak as small and medium-sized enterprises delay or cancel projects in response to the coronavirus pandemic.

The worst performer from the Dogs of the Dow list for 2020 through June 30 was Exxon Mobil Corp. (XOM), down over 35%. Exxon Mobil is the largest publicly traded integrated oil company in the world, excluding Saudi Aramco. The energy sector has struggled in 2020, at times driven simultaneously by a global price war that collapsed crude oil prices and a pandemic that slashed demand.

The Dogs of the Dow philosophy is a contrarian approach. Like all basic value-oriented techniques, the dividend-yield strategy attempts to identify investments that are out of favor. Contrarian techniques such as this are based on the premise that markets tend to overreact to news — both good and bad — and push the price of a security away from its intrinsic value.

The biggest challenge with the Dogs of the Dow strategy is that it limits its universe to a highly restrictive group of stocks — the 30 stocks comprising the Dow. These are large, well-known companies with long histories of profitability. Investors looking at high-yield stocks should always ensure that the company can continue to pay its dividend.

The stocks passing the Dogs of the Dow screen are sorted by price, low to high. Doing so makes it easy to identify those also passing the Dogs of the Dow Low Priced 5 screen, which selects the five lowest-priced components from the 10 Dow stocks with the highest dividend yields. The latter approach is even more concentrated and is more vulnerable to a major setback in one particular stock.

As mentioned above, the Dogs of the Dow approach requires an investor to buy the 10 highest-yielding stocks in the Dow at the start of every calendar year. However, if the year ended on July 10, 2020, the companies highlighted in Table 2 would make up the new Dogs of the Dow list. There are 11 companies currently passing the screen because Caterpillar Inc. (CAT) and Merck & Co. Inc. (MRK) have the same current dividend yield. There are only a few differences between the companies passing the Dogs of the Dow screen at the end of 2019 and those passing as of July 10.

There is one deletion and two additions to the list of companies that currently pass the Dogs of the Dow screen compared to the end of 2019. Cisco no longer passes the screen and has been replaced by JPMorgan Chase & Co. (JPM), the largest U.S. bank by assets, and Merck & Co., a global health care company. Big U.S. banks are set to report earnings this week for the April–June quarter. Investors will be focusing on whether the banks’ loan defaults spiked as household and business customers’ finances took a hit from the coronavirus pandemic. JPMorgan is one of the financial institutions that investors are watching for an update on how the bank sees its business shaping up for the rest of the year.

Table 2. Companies Currently Passing Dogs of the Dow: 10 Highest Yielders and Low Priced 5 Screen (Ranked by Stock Price, Low to High)

Keep in mind that no matter how well a stock screening methodology has performed (or how badly it has underperformed) over the long term, stock screening is only the first step in the stock selection process. You will want to do your homework to see why these companies are at their current levels. Only then will you gain insight into those that will continue to languish and those that may eventually flourish.

The stocks meeting the criteria of the approach do not represent a “recommended” or “buy” list. It is important to perform due diligence to verify the financial strength of the passing companies and to identify those stocks that match your investing tolerances and constraints before committing your investment dollars. Keep in mind that the quantitative screens AAII has developed are based upon our interpretations of published works tied to the market gurus.

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