Dividend Investors Are Loving This Dow Strategy In 2014

The Dow Jones Industrials (^DJI 0.56%) finally set a new record high this past week, climbing four points above its previous record level at the end of 2013. But with the Dow having moved down again to finish the week down, stock market investors are getting impatient with the Dow's weak performance so far in 2014. However, one dividend-focused strategy has managed to eke out a reasonable gain even with the broader Dow down. Let's take a closer look at the this strategy and why positive moves for Merck (MRK 0.44%) and Microsoft (MSFT -1.27%) have helped it outperform the return of the Dow Jones Industrials.

Bark and bite
The Dogs of the Dow strategy is an old-fashioned way of investing in the Dow, but many investors still use it as a simple way to get exposure to the blue-chip stocks in the Dow Jones Industrials while also boosting your dividend yield. The way it works is to pick the 10 top yielding stocks in the Dow at the beginning of every year, and then hold them throughout that year. So far this year, the Dogs of the Dow are up 2.4%, beating the Dow's decline of 0.4%. Merck and Microsoft have the best returns of Dow Dogs in 2014.

Source: Wikimedia Commons, courtesy Geo Swan.

The strategy doesn't always succeed in producing better returns, but it often has inherent advantages over simply buying the Dow outright. First, stocks with the highest dividend yields are often those that have performed badly in the previous year, and so if those stocks recover -- as they often do -- then the Dogs of the Dow strategy picks them at just the right time. Conversely, the stocks with the lowest yields often have seen above-average performance that has sent their share prices substantially higher, thereby reducing the yield even when the dividend stays stable or goes up.

Merck is a good example of a Dogs of the Dow stock that underperformed last year, although it's somewhat hard to tell given the strong performance of the Dow in 2013. Even though Merck gained more than 22% in 2013, the Dow beat it by more than four percentage points, and that bumped up the pharma giant's yield by one place in the top 10 yielding Dow stocks. Now, investors have gotten excited about Merck's prospects for developing new drugs that could in time help it replace lost revenue from established blockbuster drugs that have gone off-patent in recent years. Microsoft actually outperformed the Dow in 2013, but it has the flavor of a long-term turnaround story, with CEO Satya Nadella finally reawakening growth initiatives that have long lain dormant at the tech giant.

Source: Microsoft.

Second, by focusing on higher-yielding dividend stocks, investors can eke out solid returns even when stocks aren't seeing major gains in share price. Indeed, both Merck and Microsoft actually grew their dividends in 2013 -- Microsoft gave shareholders a 22% dividend increase in late 2013, while Merck was much more conservative in its penny-per-share quarterly increase.

Admittedly, there's no guarantee that the Dogs of the Dow will avoid losses. As of Friday, three of the 10 Dogs were down for the year. But that compares to 10 of the remaining 20 members of the Dow having seen price declines so far this year.

Dividend investors should pay close attention to the Dogs of the Dow strategy. Even if trying to beat the Dow isn't your goal, the guarantee of higher dividend income from owning the 10 top-yielding stocks in the Dow Jones Industrials is something that will fit well with many investors' goals.