No Bite Left in the Dogs of the Dow?

Buying the Dogs of the Dow is a time-honored strategy for investing in undervalued, high-yielding stocks. Rank the 30 companies in the Dow Jones industrial average by yield, buy the ten stocks with the highest yields, hold them for a year, then repeat the process. The fat yielders are screaming buys, the idea goes, because dividends paid out by a who's who of American industry are secure and because the stocks have achieved top-ten status due to weak performance, putting them in the bargain basement.

The strategy has frequently been a winner. In 2006, for example, the Dogs earned 32%, including dividends, compared with 19% for the full DJIA. But the Dogs lagged in 2007 and have fallen off the track this year.

Year-to-date through July 22, the Dogs lost 19% on a total-return basis, compared with a decline of 11% by the full industrial average and 12% for Standard & Poor’s 500-stock index (the gap was several percentage points wider before the recent rally in bank stocks). The Dogs trail despite entering 2008 yielding 4.3% on average, compared with an average yield of 1.8% for the 20 other Dow stocks.

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So much for high yields protecting capital in a bear market. The Dogs' fall from grace leads to two questions: First, is the idea of investing in the ten highest Dow yielders out of touch with contemporary markets? Second, is there a better or easier way to invest in a package of high-yielding blue-chip stocks?

Before we answer the questions, let's identify this year's dogs (you can find the list at www.dogsofthedow.com). The '08 pack, in descending order of yield at the start the year, contains Citigroup (symbol C), Pfizer (PFE), General Motors (GM), Altria (MO), Verizon (VZ), AT&T (T), DuPont (DD), JPMorgan Chase (JPM), General Electric (GE) and Home Depot (HD) ). (Although the performance of the Dogs strategy is typically measured on a calendar-year basis, you can begin the program at any time of the year. Dogsofthedow.com updates the current top yielders weekly.)

One problem with the Dogs that has been magnified this year is the heavy presence of financial stocks. And by financials, we don't mean just Citigroup and JPMorgan Chase, but also the two Generals. GE has a heavy financial-services component, and GM still owns 49% of GMAC, which is losing hundreds of millions of dollars every quarter. GM also depends on banks to finance its cars and its dealers' inventories, so it's suffering in several ways from the problems in banking and credit.

Another problem for Dogs fans is what companies are not on the list: For starters, it doesn't include energy giants ExxonMobil (XOM) and Chevron (CVX), which have performed well during the energy boom. Only two of the ten Dow stocks on S&P's list of dividend aristocrats (companies that have boosted their dividends at least 25 consecutive years) are Dogs. And those two, GE and Pfizer, have frustrated shareholders for years.

Yet another concern is the growth-versus-value tilt. The Dogs generally dig deep into the value side of the market, while faster-growing Dow companies such as IBM (IBM), McDonald's (MCD), 3M (MMM), Procter & Gamble (PG) and Wal-Mart Stores (WMT) rarely yield enough to enter Dogdom.

With investors focusing on companies that can generate growth even in a weak economy, it's no surprise that this year's top-performing Dow stocks include IBM, McDonald's and Wal-Mart. The best-performing Dog this year is DuPont, the only truly industrial company among the ten highest-yielding members of the Dow industrials.

Asif Suria, who writes the financial blog SINLetter, says several factors, beyond the impact of the subprime mess on banks, are hobbling the Dogs. Worries about changes in health-care policies could affect a drug maker such as Pfizer. And, he says, there are concerns that qualified dividends, now taxed at a maximum rate of 15%, will lose their advantage starting in 2011.

But, Suria adds, the Dogs could still recover in 2009. "Since Wall Street is forward-looking," he writes in an e-mail, "the actual events may not cause a further drop in prices but could already be factored into current share prices."

Even if the Dogs regain their bite, it's fair to ask whether the time to abandon the strategy has come. The question is particularly timely now that there are, arguably, better alternatives in the world of exchange-traded funds, which didn't exist when the Dogs strategy came into vogue in the late 20th century.

Three ETFs in particular are well positioned to deliver high dividends and cope with any shift in market leadership back toward financials and consumer companies. They may not beat the Dogs in a furious financial-stock rally, but they should deliver better returns over the long run.

iShares Dow Jones Select Dividend Index (DVY) tracks the 100 highest-yielding stocks in Dow's total market index. The ETF eliminates companies that have cut their dividends recently. The fund, which closed July 23 at $52.47, yields 4.8% based on total distributions of $2.53 per share.

PowerShares Dividend Achievers Portfolio (PFM) owns more than half of the Dow 30, including six Dogs, but it also owns scores of utilities and regional banks as well as growth-oriented industrial companies and consumer stocks. The holdings are a subset of the Mergent's Broad Dividend Achievers list, which includes more than 300 companies that have raised dividends at least ten straight years and that meet other benchmarks. TThe fund closed July 23 at $15.08, for a yield of 2.5% based on total distributions of 38 cents per share over the past four quarters.

WisdomTree International Dividend Top 100 Fund (DOO) isn't an apples-to-apples match with the Dogs. As its name indicates, it invests in a wide-ranging portfolio of high-yielding European and Asian stocks. The fund, which tilts toward banks, insurers, oil companies and utilities, focuses on companies that are expected to raise dividends as well as sport a good current yield. At its July 23 close of $61.14, the ETF yielded 2.9% based on its 2007 distribution rate of $1.79 per share.