Andrew Hallam is the index investor for Globe Investor's Strategy Lab. Follow his contributions hereand view his model portfolio here.
Twenty-five years ago, Michael O'Higgins began to write a book. The Miami-based money manager wanted to share something simple: an investment strategy that he had used since 1978. The strategy took just 15 minutes a year. But Mr. O'Higgins said it would beat the market. He completed the book in 1990. Titled Beating the Dow, it began to fly off bookshelves.
The strategy was simple: Find the 10 Dow Jones stocks with the highest dividend yields. These high-yielding stocks are commonly referred to as the Dogs of the Dow. Then buy the five lowest-priced stocks among them.
Mr. O'Higgins had back-tested his strategy to 1973. It had thrashed the market. But looking at a method's past results can be pretty foolish. History isn't a crystal ball. But was Beating the Dow an exception? The short answer is yes. From 1991 to Nov. 30, 2014, the strategy averaged 12.66 per cent a year. The S&P 500, by comparison, earned 9.99 per cent. The past five and 10-year returns haven't been shabby either. Over the past 10 years, it beat the S&P 500 by 0.91 per cent a year. Over the past five years, it beat the market by 3.2 per cent a year.
If you're waiting for the magic formula, hoping to beat the market, there are two things you should know. Mr. O'Higgins's method involves buying the Dow stocks with the worst possible prospects. If you don't have the stomach to buy what most people fear, forget it.
Second, it won't always beat the market. In the 10 years between 1990 and the peak of the market run-up, Mr. O'Higgins's method trailed the market. It gained 17.1 per cent a year compared to 18.6 per cent for the S&P 500. When it underperforms, many investors abandon it. "Most investors," says Mr. O'Higgins, "tend to 'fight the last war' by buying what has done well and selling or avoiding whatever has done poorly."
I asked Mr. O'Higgins if he knows anyone, personally, who has used this strategy since 1991. He doesn't. And that's a shame. In a tax-sheltered account, it would have turned $10,000 into $174,948 between 1991 and November 30, 2014. An equal investment in the S&P 500 would have grown to $98,451.
It might not beat the market over the next five, 10, or 25 years. But if you're willing to take the chance, here's what you need to do. First, find the 10 Dow Jones stocks with the highest dividend yields. Steady or growing dividends are a sign of financial strength. Once you identify the top yielders, you buy the five lowest-priced stocks among them. After 12 months, determine whether your holdings still meet the original criteria. The stocks that don't meet the standard get sold and are replaced by the Dow's latest pariahs.
Companies that qualify as these Dogs of the Dow usually have a few problems. Or their stock prices are suffering from apparent rigor mortis. Don't look for analysts to agree with your holdings. Most won't. But Dow stocks, according to Mr. O'Higgins, are tough to keep down forever. Because of their pedigree, even the index's unpopular members have high chances of eventually recovering. They have huge infrastructures, long histories, extensive customer bases and big revenue streams. "If the problem is poor management," he says, "new management comes in, sweeps away past policies, makes strategic changes that adjust to new realities, kicks the horse's flank to get it moving and starts making money again."
My personal money is in a diversified portfolio of index funds. But you might want to buy value stocks. Or you might want to buy big dividend payers. Such strategies, however, take time. You'll need to research. You'll need to carefully track your stocks. Instead, you could be spending that time with family, friends, or exercising.
Perhaps the Dogs of the Dow could be your solution. And who knows? You just might beat the market.
Andrew Hallam