The Dow Dogs Are Back!

With all the interest in dividend stocks lately, investors have looked for all sorts of clues to figure out which stocks are likely to perform best. But rather than trying to reinvent the wheel, Fools might want to dust off some old-fashioned investing strategies from past periods when dividends were considered equally important. After all, what's worked before can often work again -- especially when conditions are similar.

The Dogs of the Dow strategy relies heavily on dividends. Once seen as a way to consistently beat the market, the method fell out of favor when it started producing mixed results. But with the recent resurgence of interest in dividends, the Dogs of the Dow strategy may have its day once again.

Dogs, Dow, and dividends
The concept behind the Dogs of the Dow strategy is pretty simple. The Dogs are defined as the 10 stock components of the Dow Jones Industrial Average that have the highest dividend yields. Buy them at the beginning of the year, hold them until the end, and see how you've done.

The strategy actually combines favorable traits of both dividend investing and value investing. Throughout much of the Dow's history, nearly all of its components paid good-sized dividends. As a result, dividend yields would rise and fall primarily because of stock price movements, rather than changes in dividend payouts. If a particular stock went out of favor in a particular year, its yield would typically rise -- and it would therefore move to the top of the yield list for the following year. When the stock returned to good graces, it would rise, falling back to the middle of the pack in order of dividend yield -- and boosting the Dogs' returns.

2010: Year of the Dog?
Last year was a good one for the Dogs of the Dow. Of the 10 Dog stocks, DuPont (NYSE: DD  ) led the way with a 48% gain. Three other stocks rose at least 20%, including Boeing (NYSE: BA  ) , McDonald's (NYSE: MCD  ) , and Home Depot (NYSE: HD  ) . DuPont, Boeing, and Home Depot all benefited from improvement in the economy that helped their sales and profits recover from the financial crisis. Meanwhile, McDonald's kept growing even after its excellent performance over the past several years.

In contrast, many Dogs that appear in the list nearly every year because of their relatively high yields -- predominantly telecom and pharmaceutical stocks -- had lackluster returns. But in total, the 2010 Dogs averaged a price rise of 15.5%, beating the overall Dow even before you consider their dividend payments' added effect on their total returns.

As often happens, some of those high-flying stocks lost their Dog status for 2010. This year, Intel (Nasdaq: INTC  ) and Johnson & Johnson (NYSE: JNJ  ) are newcomers to the pack, after performing fairly poorly in 2010. Johnson & Johnson lost 4% as it dealt with wave after wave of product recalls. Intel eked out a 3% gain, as most of the action in technology stocks seemed to focus on smaller companies with more obvious growth prospects.

Not a sure thing
Despite the success of the Dogs of the Dow strategy in 2010, investors shouldn't feel certain that it will outperform again in 2011. Before last year, the Dogs had had a three-year run of losing to the overall Dow, falling short both in the market-meltdown year of 2008 as well as the ensuing recovery of 2009. The strategy took a particularly nasty hit from the financial crisis; both Citigroup (NYSE: C  ) and JPMorgan Chase were Dog stocks for the 2008 year, before slashing their dividends and suffering huge losses.

Still, as a common-sense way to generate investing ideas, you can certainly do worse than the Dogs of the Dow. Although its value as a mechanical investing method has largely been disproven, the general idea that out-of-favor, high-yielding dividend stocks can provide both healthy payouts and the chance of capital gains makes perfect intuitive sense. If you'd like to identify potential dividend stock candidates for your portfolio, you may want to make 2011 the year of the Dog.

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Home Depot and Intel are Motley Fool Inside Value selections. Motley Fool Options has recommended buying calls on Intel and a diagonal call position on Johnson & Johnson. The Fool owns shares of JPMorgan Chase and Johnson & Johnson. Motley Fool Alpha owns shares of Johnson & Johnson, which is a Motley Fool Income Investor pick. Try any of our Foolish newsletter services free for 30 days.

Every time Fool contributor Dan Caplinger goes to his favorite Chinese restaurant, he's reminded that he was born in a year of the dog. He doesn't own shares of the companies mentioned in this article. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy doesn't give every dog its day.


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