Can the FTSE's dogs beat the index?

Marketing bears some responsibility. Quality and growth narratives sell not only because it is easier to point to fast-expanding, high-margin companies than ones with thin profits and untapped value, but because they offer a halo of credibility by association to a fund manager.

As they used to say both in MBA textbooks and on Wall Street, “no one ever got fired for buying IBM”. Or at least they didn’t before 2013, since when the once-standout technology stock has gone sideways in a decade in which its average S&P 500 sector peer rose 335 per cent on a total return basis.

IBM (US:IBM), as it happens, is the third-oldest constituent of the Dow Jones Industrial Average, a widely tracked composite index of US stocks whose origins date back to the late 19th century. Of the 30 companies in the Dow, as it is colloquially known, IBM also has the fifth-highest trailing dividend yield, after Verizon (US:VZ), Intel (US:INTC), Walgreens (US:WBA) and 3M (US:MMM).

That makes it a dog. Or at least one of the current ‘Dogs of the Dow’, after the stockpicking method of the same name, and outlined by the investor Michael O’Higgins in his popular 1991 book Beating the Dow.

The methodology behind the strategy doesn’t involve much legwork. Once a year (O’Higgins suggests after the stock market closes on the final trading session in December), investors need only rank the Dow’s members by their trailing dividends and buy the 10 highest yielders. A year later, the process is repeated, and the stocks that fall off the list are replaced with those that are newly promoted (or should that be relegated?) into the top 10.

Despite its simplicity, O’Higgins was able to show that the method would have outperformed the Dow for much of the 20th century – a claim later supported by back-tests carried out by legendary quantitative investor James O’Shaughnessy.

Although its members and construction are a little anachronistic, the Dow is still a relevant measure of US equities. And while its returns have been eclipsed by the more tech-heavy S&P 500 in the past decade, it has outperformed its better-known benchmark cousin by around 50 basis points a year in the 32 years since Beating the Dow was published, according to FactSet total return data.

It is, in short, a reasonable representation of the diversity and might of corporate America. These features also help explain the intuitive logic behind the Dogs strategy.

Although UK investors often seek out dividend payers, US stocks with high trailing yields are more commonly seen as reflecting doubts around earnings growth. Despite this, companies that are big and successful enough to make it into the Dow tend to have well-established brands, economies of scale, plentiful access to cheap credit and smart management teams.

In other words, by taking contrarian bets on unloved (ie high yielding) large-caps, investors can look beyond markets’ propensity for short-term irrationality in anticipation of a reversion to the onward-and-upwards growth rates that propelled a stock into the Dow in the first place.

That’s the theory, at least. Unfortunately, the Dogs haven't been a source of outperformance for some time, based on disclosures on O’Higgins’ website of the same name. In the decade to 31 December, its picks have averaged 7 per cent a year before dividends, compared with 9.7 per cent from the Dow and 10.4 per cent from the S&P 500. An important point to note here is that O'Higgins’ results exclude dividends. Given the screen’s focus – and the fact that dividends improved average annual returns for the Dow and the S&P 500 by 2.58 and 2.15 percentage points, respectively – this feels like an oversight, and suggests that average annual returns from the Dogs of the Dow were likely to be closer to 10 per cent for US-based investors over this period, even after factoring in dealing charges.

New dogs, same trick

The strategy has been slightly more resilient in the UK stock market, seen by some investors as a veritable corporate dog pound to begin with. In the five years to 31 March 2022, annual reshuffles of the 20 biggest FTSE 100 dogs would have netted a faithful investor a total return of 52.4 per cent, versus 28.9 per cent from the blue-chip index.

Unfortunately, the class of 2022 didn’t fare quite so well. While three-fifths of the stocks finished in positive territory for the year, the aggregate performance of the FTSE 100 Dogs was 0.6 per cent, some way short of the index’s solid-in-the-scheme-of-things 7.8 per cent return.

Despite this, the screen is still ahead of the FTSE 100, by 14.3 percentage points, over six years. Even after factoring in a chunky 1 per cent annual dealing charge to reflect the real-world costs of rebalancing the portfolio, our UK Dogs would have returned 6.4 per centa year on average, versus 5.7 per cent from the FTSE 100.

The degree to which this year’s selections inspire confidence depends on what you are looking for. They also highlight some of the oddities of London’s premier stock group, particularly when compared with US equities.

For a start, three-quarters of the 2022 Dogs that posted a positive return over the past year have returned in this year’s cohort, as well as five of the eight companies whose shares lost money. In several cases – including high-street lender NatWest (NWG), tobacco giant Imperial Brands (IMB) and financial services outfit Aviva (AV.) – the market appears reluctant to factor recent performance into its valuation.

In each case, the reward for a year of market-beating returns is a single-digit forward price/earnings ratio and forecast yields that are between 68 and 103 per cent above the FTSE 100 average. That suggests investor concerns outweigh confidence.

Of course, outside a rules-based screening methodology, a 7.5 per cent dividend yield isn’t normally an invitation to buy. Although the average yields of our 20 Dogs are nearly 3 percentage points higher than the FTSE 100 mean, average cover ratios are much weaker at 1.6, compared with 2.4 for the broader index. The high-profile recent cuts to the dividends of income stalwarts including housebuilder Persimmon (PSN) and insurer Direct Line (DLG) will have rattled many a dividend-focused UK investor.

At a certain point, investors’ desire for cash returns in what remain straitened times for many equity portfolios should act as a floor for lots of stock prices. Then again, whether there are smarter uses of cash than transferring it to the bank accounts of shareholders will be a defining question for these companies in 2023.

Relative to their current share price, just two-fifths are expected to pay out more in dividends over the next 12 months than they did over the past 12. That suggests distributions are competing with other cash needs. This might not be a bad thing, assuming those needs are in the service of business and asset growth rather than debt. Long term, a dog’s life isn’t that desirable.