Sunday, May 7

Week 305 - Dogs of the Dow

Situation: We all know that Compound Interest is the most powerful force in the investing universe but the second most powerful force is less well known: Reversion to the Mean. That’s the force that makes many of the poorly-performing stocks from the last business cycle look good in the next business cycle. How this “magic” works is through the decisions made by investors, who either don’t put more money into a good but overbought stock (thereby marking its “high”), or do put more money into that same stock after it has become oversold (thereby marking its “low”). In the case of large and well-established companies, this “now I like it/now I don’t” oscillation can evolve faster than the normal business cycle; but for commodity-related companies it will evolve slower. Investors are eager to know when a “low” has been reached for actively traded stocks, such as those in the 30-stock Dow Jones Industrial Average (DJIA). That’s why we have “The Dogs of the Dow,” a respected investment theory that identifies high-quality but temporarily struggling stocks by their attractive dividend yields. Most DJIA stocks pay an above-market dividend, which that may go up or remain unchanged but will almost never go down. If the stock drifts lower in price, investors will be alerted to this by its rising dividend yield. Why? Because they’re getting paid more to own the stock and will tell their friends.

Proponents of the Dogs of the Dow strategy argue that blue-chip companies do not alter their dividend to reflect trading conditions and, therefore, the dividend is a measure of the average worth of the company; the stock price, in contrast, fluctuates through the business cycle. This should mean that companies with a high yield, with a high dividend relative to stock price, are near the bottom of their business cycle and are likely to see their stock price increase faster than low-yield companies.”

At the end of each year, “Dogs” are identified as the 10 highest-yielding stocks DJIA. “Dogs of the Dow Theory” instructs you to invest equal dollar amounts in each of those 10 stocks in the first week of January. You can be certain that some of those stocks will show remarkable price appreciation over the next 12 months, but most won’t. By following this Theory, your odds of beating the DJIA are better than even, but most investors think they can improve on the odds by “winnowing out” companies having a business plan that appears likely to remain ineffective longer than a year.

Mission: Subject the 2017 Dogs of the Dow to our spreadsheet-based analysis.

Execution: see Table. Metrics highlighted using purple mark issues that will reduce the chances of that stock outperforming the DJIA this year.

Bottom Line: A great deal of research backs up Dogs of the Dow Theory. And, it has more value that Dow Theory in generating an series of Buy Signals. If you learn nothing else from our blog, learn Dow Theory and use it to ignore market pundits. 

The thing to understand about the Dogs of the Dow strategy is that you aren’t going to restructure your equity portfolio every January by seeking to own equal dollar amounts of all 10 Dogs. But the list is very useful when Dow Theory is generating "Buy" signals. On such occasions, find a way to winnow the list down to 4 or 5 stocks and buy shares in companies you don’t already own. The most popular method is to pick the 5 lowest-priced, which have come to be called “Small Dogs of the Dow”. This year’s Small Dogs are Coca-Cola (KO), Verizon Communications (VZ), Merck (MRK), Pfizer (PFE) and Cisco Systems (CSCO). Two of those stocks, VZ and MRK, have S&P ratings of B/M, i.e.,  a clear message to the retail investor that these are best avoided. 

Of the remaining 3, Coca-Cola (KO) shares are likely to be the most “safe and effective” to own. Emerging markets are past the Great Recession and starting to grow, giving Coke an opportunity to capitalize on its dominant position in countries where the middle class is growing at 10%/yr. 

CSCO is attractive for a different reason. Companies around the world are finally increasing their capital expenditures faster than GDP. Computers and software are the fastest-growing class of capital expenditures. Cisco Systems (CSCO) has been increasing its sales and earnings faster that expected, and the company has been aggressively raising its dividend (see Column H in the Table). 

Returning to the full list of 10 companies, Boeing (BA) is the hands-down winner in terms of Net Present Value (see Column Y in the Table) and has no serious issues with its balance sheet (see Columns P-R). As noted above, companies are investing more in computer-managed equipment and nothing tops aircraft in that regard. For example, the Department of Defense and NASA spend over $20 Billion a year on Boeing equipment. One thing you can be sure of under President Trump is that he will ramp up expenditures on right-wing jobs programs like the military. IBM also will benefit from the above-noted increase in corporate spending on capital equipment. 

Risk Rating: 6 (where 10-Yr Treasury Notes = 1, S&P 500 Index = 5, and gold bullion = 10)

Full Disclosure: I dollar-average into both KO and IBM.

NOTE: Metrics are current for the Sunday of publication. Red highlights denote under-performance vs. VBINX at Line 18 in the Table. Purple highlights denote Balance Sheet issues and shortfalls. Net Present Value (NPV) inputs are described and justified in the Appendix to Week 256: Briefly, Discount Rate = 9%, Holding Period = 10 years, Initial Cost = average stock price over the past 50 days (corrected for transaction costs of 2.5% when buying ~$5000 worth of shares). Dividend Growth Rate is the 3-Yr CAGR found at Column H. Price Growth Rate is the 16-Yr CAGR found at Column K ( Price Return (from selling all shares in the 10th year) is corrected for transaction costs of 2.5%. The Discount Rate of 9% approximates Total Returns/yr from a stock index of similar risk to owning shares in a small number of large-cap stocks, where risk due to “selection bias” is paramount. That stock index is the S&P MidCap 400 Index at Line 24 in the Table. The ETF for that index is MDY at Line 17. For bonds, Discount Rate = Interest Rate.

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