Dogs of the FT30

First, however, it's worth outlining the background to the system. In each of the last six 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. The system was outlined in his book Beating the Dow (Harper, 1992). It has generated outstanding results, particularly when investment income is taken into account.

How it works

Investors Chronicle'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 FT30 and Dow 30. Both are indexes of big blue-chip companies, 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, sterling). 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. O'Higgins described this as the PPP stock (penultimate profit prospect). In our system I am calling it the SSS (single share selection).

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, performing particularly well in the recovery phase after a bear market trough.

Dogs of the FT30 performance

We now have data based on my FT30 version of the O'Higgins method going back to 2004. Beginners' luck meant that the best year for the FT30 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 with a 24 per cent rise in the market.

In 2005-06 the 'dogs' gained 5 per cent while the wider market was up 11 per cent, but 2006-07 again saw good performance with a rise for the 'dogs' of 42 per cent versus the market rise of 16 per cent.

Table one (above) shows in more detail how the system has done since then. The flipside of the good performance in some years is that years of bad bear markets are bad for the system. The performance in 2007-08 was dreadful, but it 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 2010-11 performance has been distinctly subdued. The five stocks the system selected a year or so ago - Ladbrokes, Man Group, BT, Vodafone and RSA - fell on average by some 7.5 per cent. That compares with a fall in the market of 1.6 per cent.

On top of this, the average historic yield on the group was some 5.3 per cent at the outset, bringing the disparity in performance down a bit. The best performer of the five was BT (up 26.5 per cent) and the worst was Man Group (down 50.8 per cent). RSA, the single stock selection last time, was down 18.2 per cent.

This year's picks

So what are the system's choices for the coming year?

The table below shows the current constituents of the FT30, ranked by historic yield. The five stocks highlighted in bold are those that the O'Higgins system would select at present on the basis of their yield.

These are, of the 10 highest-yielding shares, the five with the lowest share prices. The average projected yield of this year's selections is 7.9 per cent. Once again that's not a particularly propitious number. The system seems to do best in years when yields are higher than this. The prospective yield is also flattered slightly by the expectation of a special payment from Vodafone as a result of capturing a dividend from its holding in Verizon.

This year's selections are almost identical to last year's, namely Ladbrokes, Man Group, Logica, Vodafone and RSA Insurance. The only change is to substitute Logica for BT.

RSA is again the single stock selection, being the share in the group with the second lowest share price in absolute terms.

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 not a system favoured by commission-hungry agency brokers, but it has the virtue of simplicity.

Perhaps it's not the best system for either ultra long-term or ultra short-term investors, but it's perfect for lazy ones.

Dogs of the FT30

Patons & Baldwins