Pigs of the Dow Get Slaughtered

"Bulls make money, bears make money, but pigs get slaughtered" is an oft-quoted Wall Street saying. That may be, but in 2003 my Pigs truly brought home the bacon, returning 51% and doubling the return of the Dow Jones Industrial Average. In 2004, the strategy did not fare quite so well, but it still outperformed the Dow and easily beat the Dogs of the Dow strategy. That brings us to 2005, where heavily influenced by General Motors' (GM) (NYSE:GM) 51.5% annual decline, my Pigs got slaughtered and underperformed the Dow by more than 11%. Still, over the three years, the Pigs have a significant lead over the Dow and a big lead over the Dogs.

First, let me say that tracking the Pigs is a bit of Foolish fun for me, and although early evidence suggests that following the Pigs has some merit, it is not a method I am advocating. I much prefer hunting for undervalued individual companies, which I do every month in Motley Fool Inside Value. The Pigs originated when I decided to track the five worst-performing Dow companies of 2002. My selection criterion was percentage of stock price decline. The idea was to hold these -- Pigs of the Dow -- for a year, sell them, and reinvest the proceeds in the five worst-performing Dow companies of 2003.

The Pigs of the Dow differ from the Dogs of the Dow and Foolish Four strategies, both of which select companies based on those with the highest dividend yield at the end of the previous year. It is my premise that there are not enough Dow companies paying a significant dividend, and that a strategy based on previous year's stock price decline would yield better returns.

For example, in 2002 Intel's (Nasdaq: INTC) stock price was cut in half, the second-worst decline of all Dow companies. In 2003 it more than doubled, making it 2003's best-performing Dow company. Even today, Intel pays such a low 1.2% dividend yield that it could not qualify for the Dogs of the Dow. The lowest of the top five dividend yields in the Dow is currently 4.5%. There's a wide disparity, with the highest yield of the bottom five at just 1.12%, and none of these companies is ever likely to qualify for the Dogs of the Dow.

For 2004 the Pigs (to be tracked in 2005) were Merck (NYSE:MRK), Intel, GM, Pfizer, and Coca-Cola.

The Dogs also had the misfortune of including GM and similarly underperformed the Dow. When we check back over the three years that I've been following the Pigs, we can see the apparent advantage of following the strategy. The table gives the total return based on investing $1,000 in each at the beginning of 2003. Figures are exclusive of taxes and brokerage fees. The three-year dividend figure is approximate.

Three years is way too small a sample, and 2003 may have been the year of the super Pigs, but in his December 2003 book titled Winning With the Dow's Losers, Charles B. Carlson espouses exactly the same theory -- that buying each year based on the previous year's stock price decline will outperform the Dow. However, Carlson conducted far deeper research than my little experiment; his research goes all the way back to 1931. He calculated that such a strategy would have outperformed the Dow by an annual average of 1.2 percentage points over that time.

I'll be tracking the five worst-performing stocks of 2005 as my 2006 Pigs, which were:

• GM at -51.5%
• Verizon (NYSE:VZ) at -25.6%
• IBM (NYSE:IBM) at -16.6%
• Disney (NYSE:DIS) at -13.8%
• DuPont (NYSE:DD) at -13.4%

I still prefer my own research because what this strategy often misses is the best-performing Dow stocks, and it completely ignores other potentially great undervalued stocks outside the Dow 30. Also, strategies such as the Dogs, Pigs, and the old Foolish Four do not account for the frictional costs of brokerage fees and the tax costs of changing the portfolio each year. I track the Pigs of the Dow because it is a plausible strategy. However, the major flaw in the strategy is that companies do not simply become undervalued at year's end. Great companies can be undervalued by the market at any time of the year, and losers can stay on their losing trajectory for much longer than one year. The arbitrary nature of the sell decision may also be getting you out of a great company just in time to miss out on the next upswing in price appreciation. One last thought -- just because it was a Pig or a Dog last year doesn't mean that it can't be one next year!

To me, what really is important is the idea of searching for value in the market's castoffs, a strategy that I use in my Inside Value newsletter and outlined in "Hunting for Value: Part 1 and Part 2." If this strategy appeals to you, why don't you try out Inside Value, with the first 30 days on me? No charge. You can join the Value Team and me in our discussions and access all current and previous issues. We can talk about the market, your favorite value picks, and those on my current Watch List.

This commentary was first published on Feb. 19, 2004. It has been updated.

Philip Durell is the advisor/analyst for Motley Fool Inside Value and owns none of the companies mentioned in this article. Coca-Cola and Pfizer are Inside Value recommendations. Merck is an Income Investor recommendation. The Fool has a full disclosure policy.