George and Mary-Lynn

The Dogs of the Dow

By Bigg Success Staff
04-30-08

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Contrarian investors go against the grain. They invest in companies that are “out of favor” with other investors. These companies are often characterized by things such as a low price/earnings ratio or a high dividend yield.

Price/earnings ratio (P/E ratio) is the quotient of the stock price divided by the earnings per share. Sometimes referred to as the “earnings multiple”. For example, if a company’s stock is selling for $10, and its earnings are $1 a share, its P/E ratio is 10.

Dividend yield is the quotient of the annual dividend per share divided by the stock price. For example, if a company pays out a dividend of $1 a year, and its stock price is $20, its dividend yield is 5 percent.

If a company has a relatively high P/E ratio, it generally means that investors perceive something better in the future. For example, they may expect a relatively high rate of earnings growth. That’s why these investors are often referred to as “growth investors”.

Contrarians are often called “value investors”. They do the opposite of growth investors. They look for stocks with low P/E ratios. For any number of reasons, investors don’t have high expectations for these companies.

The dogs of the Dow

There are underdogs in every competition. In horse races, they are called “dogs” and people who mainly bet on “dogs” are called “dog players”.

That leads us to one way to make a contrarian play with stocks – the dogs of the Dow strategy. This strategy dates back to at least the early 1970s, but gained popularity in the early 1990s when Michael O’Higgins wrote Beating the Dow.

Dow refers to the 30 stocks that comprise the Dow Jones Industrial Average, the oldest and single most watched stock index in the world. To many people, “the Dow” and “the market” are synonyms.

The idea behind this strategy is to buy Dow stocks with the highest dividend yield. Those are considered the dogs of the Dow.

It’s a relatively easy strategy to implement:

  • Determine how much you want to invest in this strategy.
  • Divide that amount by 10. This will be the amount you invest in each stock.
  • After the final trading day of the year, select the ten Dow stocks with the highest dividend yield.
  • On the first trading day of the year, buy the ten dogs of the Dow stocks.
  • Repeat this process year after year. Something to note, though, is make sure you hold your winners for a year and a day so you can take advantage of the lower capital gains tax rate.

Like any stock market strategy, in some years you’ll win. In others, you will not. For example, this strategy seems to do particularly well when there is a flight to safety. You may find that being a dog player is a valuable part of your larger portfolio.

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