Why The Dogs Of The Dow Strategy Will Likely Succeed In 2023

The “Dogs of the Dow” strategy (the practice of buying the 10 highest yielding Dow 30 Industrial stocks (or a subset thereof) works better some years than others. Below, we will list the reasons why we think that 2023 will one of the better years.

The Dow Jones 30 Industrials is a highly visible index of 30 major stocks. These are typically issues of mature companies, that have large capitalizations, are representative of key industries, and are generally considered “too big to fail.” Certain tech giants like Apple (AAPL), and Microsoft (MSFT), have outperformed the Dow in the past ten years or so (despite low dividend yields), because they were admitted to the index in the late stages of their growth phases. Nevertheless, 2022 may have marked a turning point for them when they both underperformed severely. They must be considered mature companies going forward because they are among the largest market cap companies in the United States and the world indexes, which puts a lid on their growth.

If other considerations are more or less equal, high yielding stocks offer two advantages over stocks that do not have this characteristic. The first is that a high absolute yield is a useful “tiebreaker” when capital gains potential between two stocks is otherwise comparable. The second reason is that if a stock has a high yield relative to its own history, that yield is likely to fall as a result of the price rising to levels that will reduce the yield to more normal levels. (This assumes, of course, that the dividend is not cut or eliminated.)

In choosing stocks with high dividends, we are, in effect, trading volatility for income. Our posture is analogous to that of someone who sells covered call options for their premiums, at the potential sacrifice of upside potential. We believe that this is a good posture going into 2023, given the series of Fed rate hikes that have taken place over the course of 2022, and likely continuing into the new year. The Dogs of the Dow strategy stands to do well in a bondlike market characterized by high and rising interest rates, and the resulting downward pressure on stock prices. The risk is that such stocks will underperform a raging bull market like the ones that prevailed in 2019 and 2021, but that’s not likely, given the looming shadow of a coming recession.

Indeed, our proprietary model suggests that the Dow as a whole is overvalued in the 30,000s, and would be more appropriately priced in the low to mid 20,000s. This opinion is actually quite widely shared on Wall Street, where a number of houses have predicted “flat” stock returns for the rest of the 2020s. But “overvaluation” is true only for a majority of stocks in the Dow, not all of them. We consider a handful of Dow stocks bargain priced. These stocks are characterized by the fact that their prices are close to, and in some cases below the 2020 lows made in March 2020 when the Dow was briefly in the 18,000-20,000 range.

The undervaluation of a handful of Dow stocks is also captured by a “Dogs of the Dow” strategy of selecting stocks with relatively high dividend yields, and spreads relative to the index. This is regarded as a naive strategy that doesn’t always work, particularly when yield spreads are narrow.

1. Higher Yields Than Usual.

But it seems like the dog stocks (as a group), have gotten the memo about overvaluation to a greater degree than the others. The highest yielding stock, Verizon (VZ), now offers a dividend of nearly 7% of its cost. In only four of the past twenty years has this equity yielded more than 5%, and in none of those years, as much as 6%. Although it is not uncommon for the number 2 company, Dow (DOW), to be yielding around 5%, its current yield of 5.56% is high even by this standard.

There are many years when no Dow stock starts the year yielding more than 5%. This year, however, no less than four Dow stocks (the above two plus Intel (INTC) and Walgreens (WBA)) are above that 5% threshold, with two more, 3M (MMM) and IBM (IBM), just under. In the past 25 years, only in 2003 and 2009, has the Dow started with four or more stocks yielding more than 5%, and only in 2006 and 2009 has the Dow started with six or more stocks yielding more than 4.5%.

2. The Pre-eminence of “small dogs.”

The “Dogs” group has a whole lost 1% (versus a loss of 9% for the whole Dow) in 2022. But the “small dogs” (the five lowest priced dogs) lost 21%, (with four out of the five “big dogs” posting gains). As a group, the small dogs yield over 5%, versus 4.5% for the dogs as a group. “Small dogs” have seldom exhibited such a large yield spread over “big dogs;” a more normal differential is 10 basis points (0.1%). By virtue of their lower prices, the “small dogs” are more volatile than the big dogs on the decline, and will show larger “bounces” in a rebound. Meanwhile, the “dogs” are yielding about 1.9% percentage points above the Dow index, while the “small dogs” carry an average yield that is 2.5% percentage points higher than the Dow.

3. A Large Number of “Unusual” Names.

The “Dogs” strategy failed to work for many of the first 20 years of the 21st century in large part because of the large number of “perennials” that dominated the list year after year. without moving appreciably in price. These included two telecoms, Verizon and AT&T (T), and drug companies Merck (MRK) and Pfizer (PFE). Of these, Merck stock worked its way off the list in 2022, Pfizer and AT&T have since been kicked out of the index, and Verizon, as noted above, has an unusually high yield, compared to its earlier self. This has made room for formerly unfamiliar names in both the “dogs of the Dow” and the Dow itself.

The “dogs” strategy works best when its occupants are rotators. This happens when a stock makes the list by falling (or lagging) for a year or two or three, then quickly rises enough to get off the list. An ideal situation is one In fact, the best performers in the Dow are stocks that “rarely” make the Dog’s list, and bought when they are on it, then exit to bigger and better things. Past candidates of this variety have included Boeing (BA) and Home Depot (HD) in 2010, Intel and McDonald’s (MCD) in the early 2010s, Microsoft in 2013, and Caterpillar (CAT) in the mid 2010s. (American Express (AXP) came “close” to being a dog stock in 2009, and has skyrocketed since then.) More recently, temporary appearances of current “dogs” IBM at the top of the 2019 list, and Chevron (CVX) early in 2021 were good “buy” signals for these issues.

Recommendations: Our recommendations for 2023 are the five highest yielding Dow stocks, Verizon, Dow, Intel, Walgreens, and 3M. The first four of the five are also “small dogs,” (lowest priced stocks). The excluded “small dog” is Cisco Systems. We are only neutral on these shares, and those of IBM because of their tech industry overlap with Intel and their relatively low yields, compared to their recent history. Dogs Amgen (AMGN), Chevron, and JPMorgan Chase (JPM) also have dividend yields that are high relative to the Dow, but low relative to their past histories, so we consider them pricey at this time as well.