Pigs of the Dow

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

"Bulls make money, bears make money, but pigs get slaughtered" is an oft-quoted Wall Street saying. That may be, but here are some Pigs with a capital P that truly brought home the bacon, returning 51% in 2003.

The Pigs originated when I decided to track the five worst-performing Dow companies of 2002. My selection criterion was percent 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.

Sounds like the Dogs of the Dow, you say? Yet these Pigs are no Dogs. In 2003, the Dogs returned 23.6%, which at first glance seems like a good year. Yet these mangy curs failed to beat the Dow index, whilst my porcine beauties doubled the Dow by returning 51%!

The Pigs of the Dow differ from the Dogs of the Dow and the 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. Last year, it more than doubled, making it 2003's best-performing Dow company. However, Intel pays such a minuscule dividend that it could not qualify for the Dogs of the Dow. The lowest of the top five dividend yields in the Dow is 3.7%. There's a wide disparity with the highest yield of the bottom five of just 0.79%, and none of these companies is ever likely to qualify for the Dogs of the Dow.

The 2002 Pigs were Home Depot (NYSE:HD), Intel, McDonald's (NYSE:MCD), General Electric (NYSE:GE), and IBM (NYSE:IBM). They collectively declined in value by 43.6% during 2002. Below is a table of their individual performance compared with the Dow 30 and the Dogs of the Dow. All figures exclude dividends.

So what does this prove? Well, of course the Pigs had a great 2003, but can it be repeated? I can hear the statisticians and denizens of The Motley Fool's Mechanical Investing board saying back test, back test, back test! I am not a statistician, nor a mechanical investing adherent, but the Kua 'Aina Partners discussion board did help me go back seven years to 1997. During that time, the Pigs of the Dow had an average annual advantage over the Dow 30 index of 1.9% and an average advantage over the Dogs of the Dow of 4.1%. It doesn't seem much in the grand scheme of things, but compounded over several years that's a significant advantage.

Which companies are the contenders for Pigs of the Dow this year? The 2003 crop proved to be an easy selection as only five stocks declined in price during 2003. The companies are Eastman Kodak (NYSE:EK), AT&T (NYSE:T), Merck (NYSE:MRK), SBC Communications (NYSE:SBC), and Johnson & Johnson (NYSE:JNJ). Their performance year to date (YTD) suggests continued porcine superiority over both the Dow and its Dogs.

In his Dec. 2003 book entitled 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 and researched figures all the way back to 1931. He calculated that such a strategy would have outperformed the Dow by an annual average of 1.2% over that time.

I still prefer my own research to any form of mechanical investing, and what Carlson has not accounted for is the frictional costs of brokerage fees and the tax costs of changing the portfolio each year. I tracked the Pigs of the Dow because it is a plausible strategy. However, to me 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.

The Pigs may have brought home the bacon in 2003, but they could still be slaughtered in 2004!

If you are looking for great companies that are undervalued by the market, try the Motley Fool Stock Advisor.

Fool contributor Philip Durell, otherwise known as admiraltroll on the Fool discussion boards, owns no shares of any companies mentioned in this article and welcomes your feedback via email. The Fool has a disclosure policy.