Winning With the Dow's Underdogs?

Charles Carlson, CEO of Horizon Investment Services and author of several books on investing, has an interesting take on producing consistent, market-beating results. He does it by espousing a "no-thinking" type of investing.

No-thinking investing?

That's my own term for it, and although I'm no fan of formulaic investing, Carlson's method is worth a look: It tackles some of the psychological barriers that stop us from being master investors.

Winning with the Dow's losers
Buy low. Sell high. That's how you beat the market, right? Sounds simple, but it's not.

Buying while everyone you know and respect is selling is not easy; nor is it a simple task to cash out while your stocks are setting record highs with each passing day. Carlson's method attempts to circumvent these emotions, which betray our better investing sense.

In a basic sense, here's how it works:

  1. Find out which five stocks in the Dow Jones Industrial Average (INDEX: ^DJI  ) have performed the poorest over the past year.
  2. Buy those five stocks (forcing you to buy low).
  3. Hold them for one year.
  4. Sell those stocks (forcing you, theoretically, to sell high).
  5. Wash, rinse, repeat...

Got proof?
Carlson went back to the 1930s and ran the numbers: "What I discovered was that buying a basket of the Dow's worst-performing stocks (I call these underachieving stocks "Dow underdogs") and holding them for a year outperformed the Dow by a wide margin going back to 1930. What's more, the strategy has been even more profitable over more recent time periods, including the last 10 years and especially during the volatile markets since 2000."

The theoretical underpinnings make sense. Carlson is self-selecting from a group of 30 very mature, well-established businesses; there are no rocket stocks or start-ups here. And as a group, they serve as a fair proxy for the larger market (actually, to some, they are the proxy). By buying the poorest performing members of this group of 30 and holding them for a year, Carlson believes that on average, those stocks will revert to their mean, and outperform their peers.

But let's look at some hard numbers. How would this strategy have fared if you adopted it at the end of last year? Keep in mind, the Dow is up 2.7% since Jan. 1.

Company

Return

Hewlett-Packard (NYSE: HPQ  ) (36%)
Cisco (Nasdaq: CSCO  ) (8%)
Bank of America (NYSE: BAC  ) (55%)
Microsoft (Nasdaq: MSFT  ) (6%)
Alcoa (NYSE: AA  ) (33%)
   
Total* (28%)

Source: http://www.dowunderdogs.com/Performance.asp *Does not include dividends.

Yikes! Carlson admits that this year, the system doesn't seem to be working. That being said, there are still several weeks left in the year for performance to turn around.

The whole idea behind this, though, is that eventually, these behemoths all revert to the mean. If you believe that, then the bounce coming from this strategy could be huge. If you don't, you probably don't want to mess with it.

What are today's Dow underdogs?
Should you want to give the strategy a try, the worst-performing stocks of the past 12 months look a lot like the list produced this January. Just swap out JPMorgan Chase (NYSE: JPM  ) for Microsoft, and you have your five worst performers.

Also of interest, here are the five highest-performing stocks on the Dow over the last 12 months. Though I haven't read Carlson advocating for it, the inverse of his strategy would be to sell the highest performers.

Company

Return

IBM 25%
Chevron 24%
Pfizer 18%
Home Depot 17%
McDonald's 17%
   
Total 20%

Source: http://www.dowunderdogs.com/PriceChange.asp

Should you use it?
In the end, there's no "perfect" way to invest. Your investment style depends on your timeline, your goals, your experience, and your temperament.

If you're a beginning investor and just getting your feet wet, this could be an easy way to start. Or, if you're nearing retirement, don't like spending too much time on your investments, and want some relatively safe stocks, Carlson's method is a viable option.

While I find Carlson's method of investing interesting, it isn't ultimately for me. I respect what Carlson's method offers, but I like to think of being an investor as being an owner of a living, breathing organization -- not just a virtual piece of paper.

By selling and buying new sets of stocks every year -- without any research into the people behind the companies, or how they're contributing to our evolution as people and consumers -- doesn't fit with my "ownership" mindset. In my opinion, it's also not as fun as doing your own research ... but that's just me.

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Fool contributor Brian Stoffel owns shares of Intel. You can follow him on Twitter at @TMFStoffel. The Motley Fool owns shares of Cisco Systems, Intel, Microsoft, JPMorgan Chase, and Bank of America. The Fool owns shares of and has bought calls on Intel. The Fool owns shares of and has created a bull call spread position on Cisco Systems. Motley Fool newsletter services have recommended buying shares of McDonald's, Intel, Cisco Systems, Microsoft, The Home Depot, Pfizer, and Chevron, creating a bull call spread position in Microsoft, and creating a bull call spread position in Intel. Try any of our Foolish newsletter services free for 30 days. 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 Motley Fool has a disclosure policy.


Read/Post Comments (8) | Recommend This Article (36)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 11, 2011, at 3:50 PM, showme wrote:

    This is fascinating, The Dogs of the DOW were the underpinnings of the Motley Fool and the Gardner Brothers before being discredited. They had written about the strategy extensively. It's come full circle, just changing the name to the Underdogs. Recycle - Reuse.

  • Report this Comment On November 11, 2011, at 4:47 PM, TMFCheesehead wrote:

    @showme-

    Though I wasn't around when the Fool started or the "Foolish Four" were written about, this is simply a quick summary of a strategy used by someone that has a logical framework to it. As the Fool grew, so too did our varied strategies. As I said, it's not a strategy that I use. More importantly, no investor is ever done learning, and there's no harm in keeping an open mind to what others are doing.

    Brian Stoffel

  • Report this Comment On November 11, 2011, at 6:10 PM, steelejeff wrote:

    I don't think that using one year's data point is a worthwhile analysis of a long-term investment strategy. It would be instructive to see the return on the strategy each year in comparison to the Dow. Otherwise, using 1 data point to determine how well you've done seems like the worst analysis one could possibly do.

  • Report this Comment On November 11, 2011, at 6:14 PM, TMFCheesehead wrote:

    @steelejeff-

    Though I wasn't able to dig up solid numbers, the first paragraph under "Got Proof" has a quote from Carlson saying that--on average--the method beats the Dow.

    Brian Stoffel

  • Report this Comment On November 11, 2011, at 6:42 PM, ybnvsfool wrote:

    Interesting thought, however, I think I will stick with my dollar cost averaging and annual rebalancing strategy. Has woked very well over my 35 years of investing.

    Dollar cost averaging forces me to buy more shares at a low cost and to buy less shares at a higher cost. Rebalancing each year also forces me to sell high and buy low.

    Easy to do with solid stocks and very low risk. Also beat the DOW in all but 2 years.

    Not for everyone, but works for me.

  • Report this Comment On November 12, 2011, at 11:19 AM, pixal wrote:

    As best I remember from about 1999, the "Underdogs" (and most of it's many variations like Foolish Four, the New Foolish Four, Foolish 9, RP4, High Yield 10, etc.) were pretty well discredited by a statistical analysis presented by TMF when you dropped the Foolish Four Portfolio. A little research into your archives should find that analysis.

    There was a lot of interest and appeal to this simple, mechanical investing approach. Unfortunately, it's not a good substitute for doing your homework.

  • Report this Comment On November 14, 2011, at 9:47 AM, TMFConch wrote:

    More history on the Dogs of the Dow and why the Fool stopped advocating the strategy can be found in the archives in the Foolish Four Information Center: http://www.fool.com/ddow/FoolishFourInfo.htm

  • Report this Comment On November 14, 2011, at 7:35 PM, racchole wrote:

    I love the Fool for many reasons but today, it is simply because they are willing to discredit their own strategies.

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