Will the dogs have their day in 2009?

By Deputy Editor Tim Bennett Jan 09, 2009

Tim Bennett

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Just over a year ago, we advised you to steer clear of investing in 'dog' stocks. Dog lovers typically buy and hold the ten shares offering the highest dividend yield (one year's dividend as a percentage of the current share price) in an index. The portfolio is adjusted a year later to evict any stocks that have fallen out of the top ten and admit the latest dogs. As well as being simple, the strategy has made impressive long-term returns. Michael O'Higgins, who devised the original US version (the 'Dogs of the Dow' strategy), outpaced the DJ30 index by an average of 5% a year from 1961 to 1995. But 2008 was catastrophic for dog fans – last year's dogs fell an average of over 41% against 34% for the Dow Jones as a whole. So will 2009 be the year of the dog?

How the strategy works

Dogs theory is based on the idea that markets tend to overreact. They get over-excited about good news and collapse in a heap when things get rough. So, say fans, you'll always make money from the highest-yielding stocks because they will also be among the most oversold and undervalued shares in the market, which means they are among the most likely to perform well over the following 12 months. For example, if the dividend yield for a firm is usually 3% and it's now 6%, then dog theory says the share must be cheap unless the dividend policy has changed. By buying it now, you pocket a 6% income yield plus the appreciation in the share price needed to bring the yield back down closer to 3%. Sounds compelling – but there's a snag.

Why it can go wrong

High dividend yields can simply flag that firms are in big trouble, rather than going cheap. An ordinary dividend isn't like an interest payment on debt – it can be cut, or even scrapped altogether. So Dog stocks can suffer the twin nightmares of falling income and capital losses. That's exactly what happened to last year's 'Dogs of the Dow' list, which included the likes of banking giant Citigroup, which saw its shares fall 76% and its dividend slashed to $0.01 per share.

Will it work this year?

That was last year, of course. Could 2009 see the strategy's fortunes recover? We don't think so. In the midst of a recession, high dividend yields can't be trusted. Hard cash is king, not dividends that can be chopped to conserve capital. The only strategy that will work in this market is research – it's no longer enough to rely on a single indicator. Check other vital ratios – particularly measures of liquidity, such as a firm's free cash-flow yield (defined on page 21) – before diving in. We've taken a look at the ten-strong Dow 'Dogs' list as at 31 December 2008 with this in mind, and picked two that look promising.

Kraft (NYSE:KFT) – dividend yield 4.4% – is "relatively immune to tough times", says Christopher Shanahan, a research analyst with Frost and Sullivan, in Forbes. The food producer sector "only" fell by around 27% in 2008 – about 10% less than either the Dow or S&P 500. Kraft sells "products that everyone wants"; the free cash-flow yield is a respectable 6%; and the forward price/earnings (p/e) ratio just under 14. It's not dirt-cheap by any means, but it is a quality defensive stock.

Pharma giant Pfizer (NYSE:PFE) – dividend yield 7.2% – is what Eddy Elfenbein on Seekingalpha.com calls a "case study of the market's extremely low valuations". With US Treasuries yielding 1.5% or so, it seems "the market is terrified" of Pfizer. Too much so, says Fortune. The free cash-flow yield is just over 9% and the firm has a cash pile of $26bn, more than several of its rivals combined. The shares have fallen mainly on concerns about the future loss of patent protection on its top-selling anti-cholesterol drug Lipitor. The p/e is down to just over seven, a 25% discount to its peers. But add up a recent restructuring and a healthy drugs pipeline, plus the ability to fund acquisitions with ease and that juicy dividend yield, and Pfizer looks tempting.

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Published in How to invest | More articles by Tim Bennett

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