Dogs of the FT30

This means in five years of the seven that we have been using this strategy it has outperformed the broader market. The saving grace last year was the corporate action at Vodafone (VOD) and a solid performance from BAE Systems (BA.). RSA (RSA), which the strategy again picked as its 'nap' selection, performed disappointingly.

Overall, the five-stock portfolio is up 15.4 per cent over the past year (data as at the close on 26 November). Added to the prospective yield at the outset (adjusted for dividend cuts at Man (EMG) and RSA) this gives a total return of around 22.6 per cent, versus a gain on the same basis for the FTSE 100 index just short of 20 per cent.

The rules are simple. In each of the past seven years, usually in November, I select a portfolio of stocks for the coming year based on Michael O'Higgins' 'Dogs of the Dow' method, using the FT30 share index as a substitute for the Dow Jones Industrial Average.

The original Dogs approach is a yield-based passive investing system for the Dow Jones. This mechanical system was outlined in Mr O’Higgins' book Beating the Dow (Harper, 1992). It has generated outstanding results over many years, particularly when investment income is taken into account.

The IC's Dogs of the FT30 system works in a similar way. One reason for using the FT30 - a relatively little-used index these days - is the similarities between the FT30 and Dow 30. Both indexes comprise big blue chips, change constituents infrequently, and are averages of share prices rather than capitalisations. What works for the Dow should work for the FT30.

Here's how it works. Take the 10 highest-yielding stocks in the Dow Jones index (or, in this case, the FT30), and then invest an equal amount in the five that, at the time, have the lowest absolute share prices in dollars (or, in this case, pence). Leave the selections undisturbed for 12 months.

After a year has elapsed, 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 system selections for the coming 12 months and the need to reinvest the accumulated dividend income. Then sit back for another year. And that's more or less it. If any of the five selected stocks are taken over in the course of the year, simply hang on to the cash released until the anniversary review.

If you only want to pick one stock to invest in using this system, there is a method for doing that, too. Perform the selection as described above and then pick out the share with the second-lowest absolute share price. Mr O'Higgins described this as the PPP stock (penultimate profit prospect). In our system I am calling it the SSS (single share selection). In the case of the Dogs of the FT30, that aspect of the O'Higgins theory hasn't worked too well. RSA, often selected because of its high yield and consistently low-ish share price, has proved a disappointing performer. It happened this year, too.

A trend emerging from the Dogs of the FT30 is that the portfolio tends to hold its own in terms of capital growth, but beats the index substantially (perhaps by an average five percentage points a year) if dividend income is taken into account. It also seems to work better at some points in the market cycle than others. For example, it performs particularly well in the recovery phase after a bear market trough, but rampant speculation-driven bull markets are bad news for the system.

We now have data based on the FT30 version of the O'Higgins method going back to 2004, when I profiled the system in the Financial Times Money section for three successive years. 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.

The table, below, 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 just as bad for the system as raging bulls. The performance in 2007-08 was dreadful, but it set up the conditions for a good showing in the following year. Similarly, a poor showing in 2011 was offset by some impressive statistics in 2012. And 2013 continued in the same vein as the previous year, although the broad market made good gains as well.

How the Dogs of the FT30 have performed

What drives the system seems to be that it picks 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. As with Vodafone in 2013, for example, corporate buyers sometimes see more value in the shares or an astute corporate deal makes investors reassess the company.

Remember, though, that the system only works if it is pursued with disciplined inactivity, without any tinkering or second-guessing. As far as the selections for the coming 12 months are concerned, the table, right, shows the current constituents of the FT30, ranked by prospective yield. The five stocks highlighted in bold are those that the O'Higgins system would select at present on this basis. Prospective yield looks likely to be a better guide to the outcome this time round, as it factors in the possibility of further dividend cuts.

The new selections are, of the 10 highest-yielding shares in the list, the five with the lowest absolute share prices. The average projected yield of this year’s selections is a relatively low 5 per cent. That compares with the 7.2 per cent seen last year, even allowing for dividend cuts announced during the year.

As usual the selections differ only slightly from last year's, namely Ladbrokes (LAD), Man Group, Vodafone, RSA and Tesco (TSCO). RSA is again the single stock selection, being the share in the group with the second lowest share price in absolute terms.

Finally, remember our usual caveat 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.

Having said that, given current market conditions and the relatively low yield the system throws up, there’s a chance that the Dogs may have had their day for the time being. But that's a judgement that has no place in this purely mechanical system.

This year's Dogs of the FT30

*(in CAPS) This year's Dogs of the FT30