Dogs of the CAPS

I like dogs. They're loyal and friendly. And when it comes to investing, they can indeed be your best friend.

Most investors have probably heard of the Dogs of the Dow strategy. Rank the dividend-yielding stocks from highest to lowest yield, and buy the top 10. Hold for one year and a day and sell. Then do it all over again.

Four Dog Night
The Motley Fool even used to follow a strategy called the Foolish Four, which built on the original strategy by ranking those high-yielders by price -- lowest to highest -- and buying just four of the top five stocks. (If the cheapest stock is also the highest yielder, throw it out, because it's probably a real dog.) While the Fool abandoned the strategy because of doubts about its efficacy, some sites still track the Dogs of the Dow's results. Over 35 years, it's amassed a pretty impressive record, with annualized gains of 17.7%.

Like I said, I like dogs. The Foolish Four was my first foray into investing in individual stocks, so I've always carried a warm spot for it in my heart. With the Fool's own foray into its investor intelligence ratings, I thought maybe Motley Fool CAPS might be an interesting addition to the strategy. More than 170,000 professional and novice analysts have rated more than 5,400 stocks, with the best stocks earning five stars.

For the past four years, I've been tracking how using a CAPS strategy on top of the Foolish Four might hold some pleasant surprises for us. The first year saw the CAPS Dogs strategy not only outperform the original Dow Dogs theory, but also the Foolish Four, the S&P 500, and the Dow 30.

In the second year, the CAPS Dogs beat everyone handily except the Dow 30, which just managed to squeak by. The returns were a clunker on an absolute basis, but relative to any of the other strategies, the top CAPS stocks were the clear winner. They slipped in 2009 as the market staged a broad rally that was fueled in no small part by the Fed and the Treasury. I think this ultimately skewed results, but last year, we once again outpaced the pack.

Here's the 2010 list of CAPS Dogs and their returns.

*Closing prices 12/31/09 to 12/31/10. Excludes dividends, commissions, and taxes.

Because our CAPS formula included all the Dow Dogs this year, obviously those returns matched, but although the broad market averages did well our Dogs did better. I should also note that I had said I probably would have dropped the two three-star entrants -- Home Depot and Boeing -- and concentrated on just the top-rated stocks. Doing that would have dropped the returns to 14%, which still would have beaten the market.

We're back with our new list for 2011, and I think we've got a great chance to beat the averages once again. Here are the Dogs of the Dow for this year.

Qualifies for Foolish Four.

What's it all about, Wolfie?
Since all of the stocks rank three stars or better, they will all be included in our list once again. That said, if I were running this in my own portfolio, I'd drop AT&T and Pfizer, and continue looking at just the top-rated four- and five-star stocks that fit the criteria.

I'd be remiss, though, if I didn't mention that I no longer invest using mechanical investing strategies like the Dogs of the Dow or the Foolish Four. I do keep an eye on how they perform, but only for nostalgia. As smart as our Foolish investors are, this is a contrarian investing strategy that tries to stand market wisdom on its head.

If you want to get your own CAPS dog in the race, just click here to get started. It's 100% free.