Join our community of smart investors

Dogs still having their day?

James Norrington examines whether our old FT30 system's bite still matches its bark
December 11, 2015

We've all heard the one about the blindfolded monkey throwing darts at the financial pages - Burton G Malkiel's analogy of the random walk theory (that future stock price movements cannot be predicted) has become classic. The inference is that alpha is a fantastical notion and investors should just buy a tracker which is, according to the efficient market hypothesis (EMH), long-term the only true representation of available returns.

Critics of EMH point to the success of investors such as Benjamin Graham and his even more famous protégé, Warren Buffett, in exploiting anomalies where stocks have been written off or forgotten about and priced below their intrinsic value. Just as buying a benchmark market-cap-weighted index represents the ideal strategy for devotees of EMH, there are also passive approaches available for those who believe markets are imperfect. Swapping Malkiel's primate for a canine metaphor, for trying to capture returns from stocks the market has overlooked, few systems require less effort than Investors Chronicle's 'Dogs of the FT30'.

Based on the methodology used by US fund manager Michael O'Higgins to select stocks from the Dow Jones Industrial Average, for several years Investors Chronicle ran a simple no-thought screen from the small universe of the FT30 index. Like the Dow, this index of large UK blue-chips is weighted by price average and its composition changes infrequently. The system is incredibly simple; the 10 companies from the FT30 with the highest percentage dividend yield are selected and the five with the lowest share price in absolute terms go, equally weighted, into the portfolio. After one year, capital gains are calculated and the portfolio is rebalanced to include the five stocks from the universe that best meet the criteria. The sum of dividends throughout the year were added to total returns at the rebalance date, which historically occurred at the end of October.

 

Average annualised returns of 10.11 per cent since 2012

After a three-year hiatus, the system is making its comeback and an overview of the intervening period suggests that it works. Between 2012 and 2013 the selections delivered total returns of 30.17 per cent; this was followed by a loss of -11.59 per cent in 2013-14 and another gain of 16.03 per cent in 2014-5; overall £100 invested in October 2012 would have been worth approximately £133.52 three years later. The geometric mean annual return, flattening out these gains and losses, is 10.11 per cent, comfortably beating the figure of 7.03 per cent for the FTSE 100 over the same period.

An advantage of the system is that it has had comparatively low turnover, with just four changes made in three years. In 2013, BAE Systems (BA.) was swapped for Tesco (TSCO) before the reciprocal change was made in 2015. When RSA Insurance (RSA) fell out of the portfolio in 2014 it was replaced by 3i Group (III) which in turn made way for BP (BP.) in 2015.

 

2012201320142015
Man GroupMan GroupMan GroupMan Group
RSA InsuranceRSA Insurance3i GroupBP
VodafoneVodafoneVodafoneVodafone
LadbrokesLadbrokesLadbrokesLadbrokes
BAE SystemsTescoTescoBAE Systems

 

The current Dogs of the FT30 selection are listed below. The three ever-presents, Man Group (EMG), Vodafone (VOD) and Ladbrokes (LAD), have all proved decent investments over three years. With the exception of BP, still suffering from the weak oil price, all five of this year's stocks have performed well since the October rebalance. Also interesting, is that there has only really been one serious disappointment, with the sale of Tesco in October this year crystallising a -47.58 per cent loss. Annoyingly, had the system never swapped Tesco for BAE in the first place, that reversal would have been avoided and the holding reacquired in 2015 would instead be sitting on an overall gain of 87.42 per cent to date. Overall, however, the Dogs methodology buys low and sells high by its very nature and, apart from this one blip, in the past three years the system's simple rules have avoided selling out at a loss.

 

CompanyDate AddedPrice 07.12.2015 (GBp) Market Cap 07.12.2015 (£m)Dividend Yield 07.12.2015 (%)Total returns since added (%)Total returns since 30.10.2015 (%)
Man Group (EMG)31.10.2012167.42,847.094.4324.860.18
BP (BP.)30.10.2015347.663,668.417.59-8.51-8.51

Vodafone

(VOD)

31.10.201221857,888.565.1841.383.44
Ladbrokes (LAD)31.10.2012116.51,186.244.8111.2410.32
BAE Systems (BA.)30.10.2015508.516,095.294.0715.4915.49

Source: Thomson Datastream

 

Criticisms of the Dogs system

So, we have a simple and easy-to-follow system, with low turnover, that has only made one significant loss. Surely this means that the method is on to a winner, right? Not necessarily. The first point to make is that the three-year period analysed here is not long enough to properly judge a strategy. The Investors Chronicle portfolio selection is of course based on the Dogs of the Dow Jones model, which has been shown to consistently beat its parent index in simulations back to the 1920s. In the US, however, the basis for this apparent outperformance has been questioned. In an excellent article for Forbes in January 2014, John S Tobey pointed out flaws with the way back-tested performance of the Dogs of the Dow was benchmarked and criticised the simplistic methodology that, in his view, left too many questions unanswered.

Among Mr Tobey's concerns were that although the Dogs of the Dow took dividend yield as the proxy for value, there was no consideration given to payout ratio, the future growth rate of earnings (from which dividends are paid) or price performance. Summing up his view on the system's prospects for 2014, Tobey wrote: "With widespread interest in stock investing, a higher dividend yield in 2014 will likely indicate an uninteresting laggard, not an attractive bargain." Looking at the closely correlated UK market, had we run the Investors Chronicle FT30 screen in October 2013, the -11.59 per cent loss over the subsequent 12 months suggests that Mr Tobey was right.

While it is easy to point to the average annualised returns of the Dogs of the FT30, seeing more than a tenth wiped off the value of your portfolio in 2013-14 would have been no laughing matter, especially as the parent FT30 index was only 6 per cent down (based on price performance alone) and the FTSE 100, including dividends, was just above water for the year. The savage drawdown experienced by the Dogs should in itself discourage investors from viewing the system as a stress-free win. Considering the performance against benchmarks also casts serious doubts about whether a Dogs portfolio can ever achieve an optimal risk-reward profile.

Another benchmarking issue raised by Mr Tobey is also crucial. The comparison of the price-weighted Dow Jones index with the equal-weighted Dogs portfolio is not valid. Constituents with a far smaller weighting in the Dow have a proportionately greater impact on the results of the Dogs portfolio. The implication is that the historic outperformance of the Dogs could be more down to weighting than its selection methodology. This is important because investors could be taking undue idiosyncratic risks, buying a concentration of stocks in pursuit of returns that may be the reward for weighting aspects.

Returning to the UK FT30, comparing the returns of the Investors Chronicle Dogs selection to an equal-weighted version of the whole index is revealing. Just looking at the 2012-15 period, the annualised average total return of the equal-weighted FT30 is 16.41 per cent. The worst year, 2013-14, would have seen a loss of -0.81 per cent. Of course, buying a portfolio of 30 stocks requires more oversight and maintenance than the Dogs system. In addition, a set of annual reweighting trades would rack up dealing costs. Given the FT30 is comprised of more liquid blue-chip shares, it is perhaps surprising that an exchange-traded fund (ETF) provider has not yet brought out a 'smart beta' product to eliminate much of the cost of an equally-weighted strategy. Until such a product comes on the market, investors in a narrower slice of the index may want to adopt a more circumspect screening approach than the Dogs of the FT30, which is only suitable for those who combine laziness with the nerve to sit tight and ride out some pretty dicey periods of peak-to-trough drawdown.