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Thursday, April 29, 2010

Does the Dogs of the Dow theory also apply to the Sensex stocks?

What on earth is the Dogs of the Dow theory? Why would any one want to apply the Dogs of the Dow theory to the Sensex stocks? What if the theory does apply, and what if it doesn't? Let me try and answer those questions one by one.

What motivated me to even discuss such a topic? Too many new investors wanting to enter the stock market without a clear idea about what to do. Many don't even realise that making money in the stock market is a full time activity.

I have advised investors to buy index funds or index ETFs, and balanced funds - but to stay away from buying individual stocks unless they have the time and knowledge to pick their own stocks. But I know that many think I'm plain old-fashioned and prefer to enjoy the thrill of losing money quickly!

Now here is a stock investing plan that is so mechanical that it can run on auto-pilot with a maximum input of two hours effort once a year. Sounds too good to be true? It almost is - but it does seem to work.

Postulated by Michael O'Higgins in his book 'Beating the Dow', the Dogs of the Dow theory goes like this:

Every year pick 10 stocks that form the Dow Jones (DJIA) index and that have the highest dividend yield (i.e. dividend per share to price per share ratio). Allocate equal amounts of money for buying each of the 10 shares. Then sit tight for a year without even looking at your portfolio.

After one year, repeat the process by adding and deleting stocks from your portfolio in such a manner that equal amounts of money are allocated to those 10 stocks that have the highest dividend yield after one year.

Go on repeating the process for a few years - otherwise the benefits of this mechanical investing strategy may not bear fruit. Back-testing the theory with older data have apparently shown the efficacy of the theory.

From 1957 to 2003, the Dogs outperformed the Dow by about 3%, averaging a return rate of 14.3% annually whereas the Dow averaged 11%. The performance between 1973 and 1996 was even more impressive, as the Dogs returned 20.3% annually, whereas the Dow averaged 15.8%.

Why or how does the theory work? The simple assumptions are:-

1. If a stock constitutes the Dow Jones index, then it must be a 'good' stock to own;

2. If a stock is trading at a high dividend yield, then it's price may have been beaten down for some reason, or it may have substantially increased dividends (may be due to some one-off reason - like a big capital gain, or a special anniversary dividend);

3. Either way, the market will eventually recognise that a 'good' stock is going abegging and the price will rise substantially.

The problem with any mechanical or automated investing strategy is that eventually every one starts following it (if it works), and the likelihood of outperforming the Dow Jones index recedes.

So, will the Dogs of the Dow theory work for Sensex stocks? There is no reason why it shouldn't. Just flash back to 2007, near the peak of the bull market. Tata Steel acquired the much bigger Corus. The stock market gave the acquisition a big thumbs down and the stock was beaten out of shape.

Did it substantially reduce dividends? Not at all. It ended up trading at a high dividend yield, and was a prime candidate for any one choosing a Dogs of the Sensex theory.

Question for readers: Do you know of other such Sensex dogs? Do you own them? Will you buy them after reading this post?

4 comments:

Sanjeev Bhatia said...

Hi,
I heard about Dogs of the Dow Theory quite sometime ago and was fascinated by the sheer simplicity of the idea. To some exten, this is replicated in the famous "The little book that beat the market" by Joel Greenblatt. The only hitch, as I see it, is that it will almost NEVER include a high growth company. A high growth company, or sector, is very less likely to pay dividends if they can get better returns by reinvesting the surplus in their own business. There is example of Bharti Airtel which after so many years of fast track growth gave their maiden dividend last year. Liberal dividend paying companies enjoy much better shareholder confidence and are excellent bets in a downturn or bear market. On the whole, a very interesting idea to develop and implement.

Thanks once again for this excellent post.

Jasi said...

Sir,

Very interesting post!

@Sanjeev, nice thoughts, though Im not quite sure other than the fact that both are forumla based, what is common between this approach and the little book approach.

Coming back to this theory, ofcourse you are limiting yourself to a very small set of stocks. I wonder how it would fare if applied to the complete BSE universe.

Another question I have about dividends is, when i buy shares of a company I am being part owner. There by standing to benefit from its profits.
But, if im not being paid dividends, why am i buying the share? Of course im discounting the appreciation in the share price. Im not an economics guys so im sure you can pardon my ignorance for asking a seemingly basic ques :)

Thanks as always!
Jasi

sreyO... said...

This is an excellent post and every investor must keep a major chunk of portfolio amount, if not 100%, following this strategy. The rest amount can be invested with growth companies or sector; but again to do this one needs research to choose growth companies or sectors. If anyone fails to recognise growth companies then the portfolio return will take a back seat. So it should be done with professional help or better simply go with the theory.

Subhankar said...

@Sanjeev: Appreciate your comments.

You are quite correct in your observation that the Dogs of the Dow strategy excludes riskier high growth companies.

The strategy is meant to be a safer one for those who are unable to pick their own stocks.

@Jasi: Thanks.

By including non-Sensex stocks, the strategy will become a lot riskier.

Dividends play an important role only if you reinvest them. Most investors buy stocks for capital appreciation - which can be a hedge against inflation.

Only stalwart stocks acquired at very low prices give good dividend yields.

@sreyoskar: Thanks for your comments.

This particular strategy, and similar ones, like the Fool's Four, have been around for a while - as Sanjeev has mentioned.

It works well for those who don't want to spend time or energy on picking and following stocks on a regular basis.