In November in each of the last five years, we have selected a portfolio of stocks for the coming year based on the O'Higgins' 'Dogs of the Dow' approach, using the FT30 share index as a substitute for the Dow Jones.
Michael O'Higgins is a Miami fund manager. Some years ago, he devised a yield-based passive investing system for the Dow Jones Industrial Average. It has generated outstanding results, particularly when investment income is taken into account.
The IC's 'Dogs of the FT30' system works in a similar way. One reason for looking at a system for the UK using the FT30 – an index that is little used today - is the similarity between the FT 30 and Dow 30. Both are indexes of big blue chips, change constituents infrequently, and are averages of share prices rather than capitalisations.
The system takes the 10 highest yielding stocks in the Dow Jones index (or, in this case, the FT30), and then invests an equal amount in the five that, at the time, have the lowest absolute share prices in dollars (or, in this case, pence). The selections are then left undisturbed for 12 months.
After a year has elapsed, the next job is to calculate the capital gains or losses, tot up the dividend income banked in the meantime, perform the exercise again, and change the portfolio where necessary to reflect the new year's system selections and the need to reinvest the accumulated dividend income. Then sit back for another 364 days. And that's it.
If you only want to pick one stock to invest in using this system, there is a method for doing that too. Simply perform the selection as described above and then pick out the share with the second lowest absolute share price.
What seems to be emerging from the results of applying this system to the FT30 is that the portfolio thus selected tends to hold its own in term of capital growth alone, but beats the index substantially (perhaps by an average five percentage points a year) if reinvested dividend income is taken into account. It also seems to work better at some points in the market cycle than others.
Beginners' luck meant that the best year for our version of the system in both absolute and relative terms was 2004/05, when the stocks selected at the beginning of the period gained 117 per cent, with an 11 per cent average yield on top, compared to a 24 per cent rise in the market. Perhaps coincidentally, the system has done well in alternate years since then – in 2006/07 and 2008/09 - when capital growth was double the market's gain or more. The flipside is that years of bad bear markets are bad for the system. The performance in 2007/08 was dreadful, but set up the conditions for a good showing in the following year.
What drives the system seems to be the stocks that the market has either written off, forgotten about, or that it believes may be planning to cut their dividends. Because the market often overdoes the gloom, stocks like this are frequently priced too low. But the system only works if pursued with disciplined inactivity, without any tinkering or second-guessing.
In 2009/10 performance has been distinctly subdued. The five stocks the system selected 12 months ago – Ladbroke, Man Group, RSA Insurance, Vodafone and BT - rose on average by some 6.7 per cent. That compares to a gain in the market of 10.5 per cent. On top of this the average historic yield on the group was some 7.2 per cent at the outset although a dividend cut at Ladbroke probably in the event trimmed this by maybe a percentage point, suggesting a total return over the course of the year of about 12.7 per cent. The best performer of the five was Vodafone (up 22 per cent) and the worst was Man Group (down 15 per cent). Ladbroke and RSA, which vied to be the single stock choice last time round performed similarly as things turned out, both up by a fraction over 5 per cent.
So what are the system's choices for the coming year?
Dogs of the FT 30 System: 2010/11 selections
|Name||Price (£)||Proj. Yield (%)||Price change over one year (%)|
|RSA Insurance Group||1.31||6.69||5.7|
|British American Tobacco||23.80||4.81||22.7|
|Tate & Lyle||5.02||4.68||11.6|
|Marks & Spencer||4.27||3.62||25.6|
|Lloyds Banking Group||0.69||n/a||20.4|
|Royal Bank of Scotland||0.45||n/a||2.9|
|Source for data: Sharescope|
|Prices as at opening on 1 November 2010|
The table shows the current constituents of the FT 30, ranked by yield. The five stocks highlighted in bold are those that the O’Higgins system would select at present. To recap these are, of the ten highest-yielding shares, the five with the lowest share prices. The average yield of this year's selections is 5.5 per cent. That's not a particularly propitious number. The system seems to do best in years when yields are higher than this.
This year's selections are, in fact, identical to last year's in every respect, namely Ladbrokes, Man Group, BT, Vodafone and RSA Insurance.
The single stock system again sees Ladbroke and RSA vying for the honour, with RSA Insurance possibly the better choice by virtue of its slightly higher yield.
Finally, remember that the system is purely mechanical and should not be pre-empted or interfered with. Fundamentals, forecasts, charts, consensus views of analysts or any of the normal stuff of investment decision-making does not come into it. The only numbers used are dividend yield and price. It's that simple.