The Dogs of the Dow investing strategy looks for deep value among the market's bluest of blue chips. The basic idea is simple: Find the highest dividend yields among the 30 Dow Jones Industrial Average (DJINDICES:^DJI) members, invest in these high-quality stocks while they're cheap, and sit back to enjoy the long-term benefits.
But high dividend yields are not a perfect measure of a Dow stock's cyclical performance, as the Dogs of the Dow model assumes. Telecom giant Verizon (NYSE:VZ) provides a perfect example of this problem. Verizon's stock has provided one of the highest yields on the Dow for years, even as its share prices marched ever higher during the smartphone boom. Verizon still offers the second-highest yield on the Dow today, second only to sector rival AT&T (NYSE:T). The low-growth cash machines of the telecom industry churn out stellar dividends regardless of short-term cycles in their share prices.
What if we shine a different light on the Dogs of the Dow strategy? If you look for high dividend yields and a struggling share price performance in 2013, you should end up with a more focused list. Here, the value implications of a high yield are paired with short-term struggles that hold share prices back.
Through this lens, three Dow tickers stand out as potential turnaround candidates in 2014.
Yes, AT&T makes an appearance. The Dow's highest yield of 5.3% comes with the third-worst stock performance. Year to date, AT&T shares have gained just 1.6% versus the Dow's 21%.
At 3.4%, McDonald's (NYSE:MCD) offers the fifth-highest dividend yield on the Dow. Moreover, McDonald's shares have risen just 8.1% in 2013, landing the fast-food slinger among the bottom five performers.
Finally, Chevron (NYSE:CVX) pairs the sixth-fattest yield (3.3%, just behind McDonald's) with the eighth-lowest price gains (11.9%).
If you buy into the Dogs of the Dow philosophy, you have to assume that AT&T, Chevron, and McDonald's are high-quality companies whose stocks are on a temporary fire sale. Again, I've tempered the basic Dogs template with a closer look at recent underperformers, so we're not looking at a simple list of high-yielding cash-cow business models.
The leaders of the pack
Of these three potential Dogs, Chevron looks like the most likely rebound play in 2014. Chevron has suffered from a rickety geopolitical climate in 2013 that played havoc with oil prices. Against a stabilizing political background, Chevron's top-notch management team should be able to come back stronger.
McDonald's is under fire for insensitive budgeting advice to its underpaid employees. Investors worry that the Golden Arches might sag if minimum wage levels are adjusted on the federal level. But then you're forgetting that very few fast-food chains can match McDonald's' returns on invested capital.
The company has freedom to adjust to a changing wage rulebook and watch its less efficient rivals squirm. If McDonald's manages a minimum wage boost correctly on both the executive and marketing levels, the penny-pinching monster could become a generous figure in the public eye.
So McDonald's shares are cheap, the company looks poised to deliver in 2014, and the minimum wage debacle could turn into an asset. All it takes is a steady hand at the rudder.
This dog might not hunt after all
AT&T faces the biggest challenges in this trio. Smartphones are still selling like hotcakes, but the service plans that make them profitable are getting simpler across the board. Smaller telecoms are banding together to create larger AT&T rivals with strong economies of scale. Ma Bell has started losing sales to these rising stars.
Turning AT&T around in 2014 is not an impossible task, but the company's management must make some drastic changes to its customer acquisition tactics. AT&T has always relied on its sector-crushing scale and solid reputation to set it apart from smaller and less experienced networks. That's not good enough anymore, and AT&T needs to become a leader instead of following industry shifts a couple of years after their invention.
The Foolish takeaway
There's my pack of dogs for 2014. All of them are up against formidable challenges, which explains their discount pricing. But that's what contrarian investing is all about -- grab the deep-discount stocks just before they bounce back. Chevron and McDonald's look like good bets for the coming year; I'm more worried about AT&T.
Fool contributor Anders Bylund has no position in any stocks mentioned. The Motley Fool recommends Chevron and McDonald's. The Motley Fool owns shares of McDonald's. Try any of our Foolish newsletter services free for 30 days.