Low-cost stocks keep on winning

The ‘Dogs of the Dow’ strategy involves the 10 stocks of the Dow Jones Industrial Average with the lowest price-to-earnings ratios. These low-cost stocks subsequently beat both the overall Dow and the 10 Dow stocks with the highest price-to-earnings ratios.

DogsoftheDowWhen an investment strategy succeeds, it attracts followers. The trouble is, if too many investors use the same strategy, it often stops working.

The ‘Dogs of the Dow’ still works

One exception is the ‘Dogs of the Dow’. Under this rule, you buy the 10 dogs of the Dow Jones Industrial Average, or DJIA. Stocks that are derogatorily referred to as ‘dogs’ are those that have dropped in price. But their former underperformance also means that these stocks are cheap. In the subsequent year, they typically beat the other 20 stocks of the DJIA and, in particular, the 10 costliest stocks. After all, the costliest stocks already had lofty earnings expectations built into their share prices. When they eventually fell short of these expectations, the market punished them and made them part of the latest group of dogs.

In The Globe & Mail, Norman Rothery has referred to the results found by James O’Shaughnessy, the author of the book What Works on Wall Street. Mr. O’Shaughnessy grouped the 30 DJIA stocks into one of three groups based upon their P/E (Price-to-Earnings) ratios. He examined the period from June 30, 1937, through June 30, 2004.

Buy top-quality stocks with low P/Es

During this 67-year period, the 10 Dow stocks with the lowest P/E ratios advanced at an average yearly rate of 9.2 per cent. This was well ahead of the seven per cent average yearly rate of the overall Dow. The 10 stocks with the highest P/E ratios inched up at an average yearly rate of only 3.2 per cent. Mr. Rothery’s research shows that this strategy continued to work up to 2017.

Based on this evidence, you should buy the 10 Dow stocks with the lowest P/E ratios at the end of each year. Sell any that now have a P/E ratio above the bottom 10 stocks. This strategy should pay off over time.

The ‘Dogs of the Dow’ strategy provides you with another benefit worth keeping in mind. Most stocks with low P/E ratios are that way because their share price has fallen. Low share prices raise the yield of dividends. That is, you stand to earn more cash as well as superior share price gains.

Following this strategy will lead to some trading costs, of course. But brokerage fees have plunged over the years, particularly at discount brokerage firms that trade online. In addition, the DJIA stocks are among the most heavily-trades stocks. This liquidity significantly narrows their bid-ask spreads (the gap between the most a potential buyer will pay and the least a potential seller will accept). Low trading costs make the higher returns on the strategy even better.

Your dogs need to survive

Buying the dogs of other indices may not work as well. After all, some companies go bankrupt. And before they do, they often trade at low P/E ratios. The 30 stocks that make up the DJIA are much larger than most. This reduces their chances of going bust. Also, they’re more apt to receive bailouts. Remember, ‘too-big-to-fail’ car manufacturers and foreign banks receive bailouts from national governments. Small companies have to fend for themselves.

Stock market observers other than Mr. O’Shaughnessy and Mr. Rothery have noticed the successful strategy outlined above. One was Benjamin Graham, the father of fundamental stock analysis. Another was Michael O’Higgins who seems to have coined the term ‘Dogs of the Dow’.

Ignore this criticism of the strategy

Writing in Forbes recently, John Tobey criticized the strategy. He said that most practitioners weight the stocks equally. The DJIA, by contrast, uses price weighting. But equal weighting seems to work. Mr. Tobey said that in 2013, under the price weighting method, the “Dogs would have returned less, rather than more”.

We should expect the ‘Dogs of the Dow’ strategy to eventually become less effective as its success becomes better known. But since the strategy has succeeded decade after decade, you might profit from buying the 10 DJIA stocks with the lowest P/E ratios.

This is an edited version of an article that was originally published for subscribers in the October 5, 2018, issue of The Investment Reporter. You can profit from the award-winning advice subscribers receive regularly in The Investment Reporter.

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