Here’s a Look at the Dogs of the Dow Investment Strategy

1. The Traditional Dogs of the Dow Approach

The Dogs of the Dow approach involves buying the highest-yielding stocks in the Dow Jones Industrial Average. It’s based on the idea that a high dividend yield is an indicator of an undervalued stock.

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To apply this approach, at the end of each year, you pick the 10 stocks with the highest dividend yields from the 30 stocks that make up the Dow index. You then invest an equal dollar amount in each of these 10 stocks and hold them for one year. You repeat the selection process and re-jig the portfolio at each year-end. In theory, these stocks should outperform the market (the DJIA or the S&P 500).

2. The Small Dogs of the Dow Approach

In another variation, you pick the 10 highest dividend-yielding stocks, then select the five with the lowest stock price. Invest an equal dollar amount in each of those, hold them for a year, and repeat. This variation is known as the Small Dogs of the Dow, or simply The Dow 5.

Here’s a Dogs-of-the-Dow ETF

The ALPS Sector Dividend Dogs ETF (symbol SDOG on New York) follows its own version of the Dogs-of-the-Dow strategy. It picks five stocks with the highest dividend yields from each of the 10 sectors of the S&P 500 index. These sectors are consumer discretionary, consumer staples, energy, financials, health care, industrials, information technology, materials, telecommunication services, and utilities.

Each holding begins with roughly the same dollar value, so every company starts out with a similar influence on the ETF’s total return. The end result is a portfolio of 50 large-cap stocks.

Currently, the fund now holds a number of stocks we recommend as buys for subscribers of our Wall Street Stock Forecaster advisory. They include AT&T, Verizon, Kraft Heinz, Snap On, 3M, Newmont Mining and IBM. However, the ETF also holds a lot of stocks we don’t recommend.

Should You Follow the Dogs of the Dow Approach?

One best-selling book of the early 1990s advised investors to buy the Dogs of the Dow—the lowest-priced, highest-yielding Dow stocks. Followers of the approach made money. Of course, anybody who bought stocks in the early 1990s made money.

The Dogs of the Dow strategy worked well in the 1990s because interest rates were going down. This tended to raise all stock prices. But high-yielding stocks were affected more than most because they attracted bond investors who were switching into stocks.

That’s how things work with most formulaic approaches: Sometimes they seem to add value, because they happen to lead you to invest in stocks that were likely to go up for some reason other than the formula’s actual focus.

Of course, you also need to keep in mind that high yields can signal danger, rather than a bargain.

All in all, we don’t recommend the Dogs of the Dow strategy.

Here’s why high yields can be a danger sign

To reiterate: a high dividend yield may be a danger sign. It may mean insiders are selling and pushing the price down. A falling share price makes a stock’s yield goes up (because you still use the latest dividend payment as the numerator to calculate yield—but the denominator, the price, has dropped). But when a stock does cut or halt its dividend, its yield collapses.

A classic case is the now defunct Yellow Pages Income Fund. When it first issued units in 2003, it was widely trumpeted by brokers and in the media as a well-established company (although we viewed it as the over-the-hill division of a formerly well-established company).

The company stayed in the limelight even though its high dividend yield—consistently above 10%—was a big warning sign. We never recommended the shares of Yellow Pages Income fund, advising investors to stay away from them.

In August 2011, the company’s credit rating was downgraded to junk status; in September 2011, it cut its dividend altogether. By then the yield was above 30%. The company has since restructured to cut its massive debt and re-emerged as Yellow Pages Ltd.—but the original shareholders of Yellow Pages Income Fund got nothing in the reorganization.

Here’s why top-quality dividend stocks are a key part of a sound portfolio

If you stick with top quality high dividend yield stocks, the income you earn can supply a significant percentage of your total return—as much as a third of your gains. And at the same time, dividends are more dependable than capital gains as a source of investment income.

Note, though, that when it comes to investment safety, a long history of steady dividends is more important than a current high dividend yield.

Final word: Good dividend stocks are a valuable component of any sound investment portfolio.

Do you follow the Dogs of the Dow? How has it worked out for you?