Dogs of the Dow 2011

A popular investment strategy for income-oriented investors is the "Dogs of the Dow" strategy.  The strategy includes purchasing the ten highest yielding stocks of the Dow Jones Industrial Average and giving an equal weight to each stock at a point in time (usually the beginning of the year).  After the one-year period, an investor sells the total value and allocates to the new Dogs of the Dow.  The idea of the strategy is that each of the stocks produces a high yield because each stock is undervalued.  Investors will see the high yield of these companies and will invest in these names, thus driving up the price of each stock.

Over time, this investment strategy has been moderately successful for investors.  For example, in 2010, the "Dogs" outperformed the Dow by about 4%, gaining 15.5% versus the Dow's 11% increase.  Including dividends, the "Dogs" outperformed the Dow by 7%, gaining a total return of 21% versus 14%.  On the other hand, investing in this strategy would have trailed the market between 2004 and 2009.   

Two key themes make this strategy attractive to investors.  First, the extension of the Bush-era tax cuts will keep taxes on dividends low relative to income making investing in dividend stocks attractive.  Second, with Treasury yields at historical lows and uncertain inflation picture, investors will likely do better investing in stocks versus Treasuries.

While the political/economic landscape makes this strategy appealing, I have some problems with this strategy.  First, the strategy does not give any weight to future earnings power of each of these companies.  If earnings are to remain flat or decline, the dividend payout ratio will increase.  This may force each company to cut the dividend.  This is a concern as a longer-term investor.  Second, its does not give any weight to the quality of the balance sheet or cash flow generation of each company. 

In my opinion, as a value investor interested in income, these stocks (or this type of strategy) is very attractive.  Instead, I would like to look at the general market to find stocks that generate cash, have strong balance sheets, and with consistent and increasing earnings.  These three factors will only ensure higher future dividends.  Furthermore, I would like to hold a name for more than one-year.

Are there other ways to play this strategy?  As an income investor, I would have a 70/30 split between these names and U.S. Treasuries.  Investing in Treasuries will provide a hedge against declining stock prices.  Given the current interest rate environment, I would recommend investing in Treasuries with a maturity of five years or less.  Since these securities are less affected by an increase in interest rates, an investor will be not see a decrease in the value of the Treasuries in the portfolio.

My goal is to analyze the Dogs of the Dow over the next few months and provide my insights to whether or not these are "great companies" to invest in.  My opinion is that some of these companies are trading at low valuations for a reason because the current economics do not appeal to investors over the long-term, while others are just undervalued by the market.

The 2011 Dogs of the Dow (source - WSJ):
AT&T
Verizon
Pfizer
Merck
Kraft Foods
Johnson & Johnson
Intel
DuPont
McDonald's
Chevron