Dogs of the Dow: A Twist on the Dow Investing Strategy, with 5 Stocks On the "Fly"

by Mark Skousen
Dogs of the Dow: A Twist on the Dow Investing Strategy, with 5 Stocks On the "Fly"

by Dr. Mark Skousen, Chairman, Investment U Friday, October 20, 2006: Issue #596

Since 1928, the Dow Jones Industrial Average (DJIA) has consisted of 30 top U.S. companies. Until the 1980s, they were entirely industrial in nature. But since then, several additions have significantly changed the Dow's composition...

Financial giants Citigroup (NYSE: C), AIG (NYSE: AIG) and American Express (NYSE: AXP) have made their way into the mix, for example. And, of course, technology companies have, too, such as Microsoft (Nasdaq: MSFT) and Intel (Nasdaq: INTC).

And now that large caps are outperforming small caps (at least for the past three months), it's time to revisit various Dow investing strategies, specifically Dogs of the Dow, as a highly profitable way to uncover today's best bargains...

The Strange Dow Jones Case of IBM and Coca Cola

Over the past 78 years, Dow Jones has made 50 substitutions in the Dow, with some odd and amazing changes...

  • In 1932, at the bottom of the Great Depression, International Business Machines (NYSE: IBM) was added, then suddenly removed in 1939, only to return 40 years later in 1979.

  • Coca-Cola (NYSE: CCE) was also added in 1932, then removed in 1935, and returned in 1987.

If IBM and Coke had remained in the Dow throughout, the DJIA would be at least 20,000 today.

Professor Gary Smith and some of his colleagues at Pomona College compared the return of two portfolios: one was composed of the stocks added to the Dow, and one was made up of the deleted stocks. After 250 trading days, Smith & Co. discovered that the deleted stocks earned an annualized return of 15.8%, compared to only 11.4% for the added stocks!

Why? Professor Smith's "Regression to the Mean..."

Smith states, "Dow Jones tends to replace companies that are not in as dire straits as their recent performance suggests with companies that are not as stellar as they appear."

For example, when Dow Jones added IBM in June 1979, the company already had a huge run-up. And Dow Jones dumped Chrysler, now DaimlerChrysler AG (NYSE: DCX), after it threatened bankruptcy. IBM floundered in the 1980s, while Chrysler flourished after getting bailed out.

One of the Dow's biggest blunders took place in November 1, 1999, when they added Microsoft, Intel, Home Depot (NYSE: HD), and SBC Communications (now under AT&T's name) to the list, all near their all time highs. Each is sharply lower seven years later.

They replaced the following companies/stocks:

  • Chevron (NYSE: CVX)

  • Goodyear Tire & Rubber (NYSE: GT)

  • Union Carbide,

    and


  • Sears (Nasdaq: SHLD)

But Dow did well by deleting these stocks, which are all down sharply with the exception of Chevron (which is up 60%). Union Carbide went bankrupt.

The Dogs of the Dow Investing Strategy

I would not recommend investing in deleted Dow stocks. A much better strategy is to invest annually in the Dogs of the Dow, the 10 highest-yielding Dow 30 stocks. (Switch just once a year to the top 10 highest dividend payers.) Since 1973, the Dogs of the Dow have returned 17.7% vs. 11.9% for the Dow 30.

But there's an even better strategy...

Invest in the "Flying Five," which are the five lowest-priced stocks of the 10 Dogs of the Dow. I've recommended the "Flying Five" strategy each August since 1991 with great success, except in the past six years, when the returns have been volatile and "everyone" started playing the Dogs of the Dow or Flying Five strategy. Take a look at how they've performed in the table below...

Dogs of the Dow/Flying 5

Years

Gain/Loss

1991-92

+13.6%

1992-93

+37.1%

1993-94

+25.0%

1994-95

+21.7%

1995-96

+24.9%

1996-97

+49.0%

1997-98

+19.4%

1998-99

+18.3%

1999-00

-30.0%

2000-01

+30.1%

2001-02

-18.7%

2002-03

+14.2%

2003-04

-8.0%

2004-05

+ 4.3%

2005-06

+10.0%

2006-present

+8.7%

Right now, the Flying Five are:

  • Verizon (NYSE: VZ)

  • AT&T (NYSE: T)

  • Merck (NYSE: MRK)

  • Pfizer (NYSE: PFE)

  • General Motors (NYSE: GM)

As you can see, stocks with high yields and low prices signify a troubled past or present.

The Flying Five Dogs of the Dow strategy is a contrarian way to uncover cheap stocks. And most of the time, it works for investors.

Good investing, AEIOU,

Mark

P.S. At the end of every trading day, The Oxford Club updates all of its portfolio returns online so members can check them out. This morning, all but one of Alex Green's 29 recommendations in the Club's Trading Portfolio are profitable. I urge you to take a look at the full list of benefits the Club has to offer - great stock picks are just one reason to join.

Today's Investment U Crib Sheet

  • This isn't the first time we've looked at Professor Gary Smith's research. Take a look at Investment U Issue #591, "Clever" Ticker Symbols: Testing the Track Records of FUN Stock Tickers, and #593, Best Stocks To Invest In: Revealing the 10 Companies Worth A "Fortune"

    If you'd like to see all of his recent reports, you can find them on his website.


  • I've already mentioned that the Dogs of the Dow Flying Five strategy is a contrarian investment approach. Take a look at one of our classic Investment U reports: the top six contrarian investors of our time.
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