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The Dogs of the Dow Theory proved it was worth its weight in gold in 2010, beating Wall Street and making a mockery of active fund managers with its simple elegance.

The strategy, which calls for buying and holding only ten stocks, has been for a long time the definition of simple market beating strategies.

Dogs of the Dow Theory Algorithm

The Dogs of the Dow theory is based on the idea that you can beat the market by investing in the highest-yielding Dow Jones Industrial Average members for a period lasting only one year.

Each year, those who subscribe to the Dogs of the Dow are supposed to rebalance their portfolios so that the new year includes 10 of the then highest-yielding components on December 31. Each stock is to be weighted equally at 10% of the portfolio value.

While dividends are excellent in any form, this algorithm has some inherent benefits:

• 1)Though dividends themselves may not rise, dividend yields can rise easily with a decrease in share price. Thus, individual Dogs are likely being purchased at their lows, or at least, lower than they were in the year previous.
• 2)The algorithm is designed not to encourage excessive reallocation, research or time investment into the strategy. Instead, investors need to rebalance portfolios only once per year.
• 3)It involves only high quality, blue chip stocks, since the Dow Jones Industrial Average is used as the source for finding stock laggards.
• 4)The Dogs of the Dow requires tactical reallocation. That is, the buy and sell procedures are set in stone and as such, individual traders are more likely to sell wild winners and add to temporary losers.

Historical Performance

In 2010, the Dogs of the Dow was successful at beating the Dow Jones Industrial Average. A portfolio of the 2010 Dogs of the Dow would have generated a return of 15.5% excluding dividend income. To compare, the DJIA managed only 11% through 2010.

With dividends included, the Dogs returned an impressive 21% compared to the Dow’s 14% capital appreciation plus dividend return.

Dogs of the Dow Funds

Admittedly, returns aren’t always so exceptional. Two funds, neither of which are purely Dogs of the Dow subscribers, Hennessy Balanced (HBFBX) and Hennessy Total Return (HDOGX), follow the basic guidelines. HBFBX buys 50% Dogs of the Dow while HDOGX allocates 75% of the assets to the Dogs. The remaining 50, and 25% is invested in treasuries set to mature within one calendar year.

Since inception in March of 1996, Hennessy Balanced (the 50/50 Dogs/Treasuries fund) has been whipped by funds in its class. At the time of writing, the fund would’ve turned $10,000 into $17,623.23 while funds of similar exposure would’ve brought $23,151.83 in the same period.

The Hennessy Total Return (HDOGX) fund performed better, but still not great. The fund, since inception in 1998 would’ve turned $10,000 into $14,068.81. The same amount invested in a large cap value fund would’ve brought $15,135.29, and the S&P 500 would’ve turned your $10,000 into $13,923.54.

Data can be found at Morningstar: HBFBX, HDOGX.

Dogs of the Dow 2011

The 2011 Dogs of the Dow are below. I included the names, tickers, price (as of 12/31/2010), and yield in both text and image format.

Company Name	Ticker Symbol	Price	Dividend Yield
AT&T	T	$29.38	5.85%
Verizon	VZ	$35.78	4.57%
Pfizer	PFE	$17.51	4.22%
Merck	MRK	36.04	4.22%
Kraft	KFT	31.51	3.68%
Johnson & Johnson	JNJ	$61.85	3.49%
Intel Corp.	INTC	$21.03	3.42%
Dupont	DD	$49.88	3.29%
McDonald’s	MCD	$76.76	3.18%
Chevron	CVX	$91.25	3.16%

This set of 2011 Dogs looks extremely strong. With the exception of Johnson & Johnson and Intel, the other eight companies are back for a repeat year. Here are some of my (quick) thoughts on each stock:

• 1) Verizon is a dividend king, but the Verizon iPhone is why I really love this stock.
• 2) Pfizer is a perennial favorite, as is Merck.
• 3) Kraft is a solid, non-cyclical play, and so too is Johnson and Johnson.
• 4) Intel may benefit from business spending with companies sitting on some $1 trillion in cash.
• 5) McDonald’s is another recession-resistant play.
• 6) Oil exposure in Chevron should play well in 2011 for cyclical commodity rebound.

Dogs of the Dow Criticisms

There have been plenty of complaints about the methodology, practicality, and performance of the popular Dogs of the Dow investing strategy. Many of these complaints are well reasoned, and frankly, I fall on the side of avoiding the strategy.

I see the Dogs of the Dow as a great way to promote income investing and dividend reinvestment plans, which I think are just about the best thing in the world. I also see it as a great way to get people interested in strategies, algorithms, and techniques that provide for market beating returns. However, I don’t see it as a very practical investment alternative, mostly for the following reasons:

Ease

First, the Dogs of the Dow, when compared to the “set it and forget it” investment strategies of buying and holding index funds is, well, a bit complex. Most investors automate their investing by deducting weekly, bi-weekly, or monthly amounts from their paycheck that are then put in index funds via tax privileged IRAs or 401ks. To require these people find the 10 Dogs of the Dow and divide their investment capital in this era of “lolwhat” personal finance is just too much work!

Transaction Costs

We should also take into consideration the transaction costs of buying and selling the Dogs of the Dow. Round trip, an investor would pay $7 to buy and sell for 10 different stocks at the beginning and end of the year via Scottrade, or $140 annually. Reinvesting the dividends quarterly makes this strategy even more expensive.

The two Hennessy mutual funds charge a whopping 1.73%, and 1.27%. The worst part about the fees? The fund with the higher annual fee, HBFBX, is 50% invested in one-year bonds. As of January 5th (the time of this edit) one-year treasuries yield .31%. I’d like to meet a financial advisor who could honestly recommend their clients pay 1.73% per year to make .31%.

The SPDR Dow Jones Industrials ETF (DIA), better known as Dow Diamonds, has a net expense ratio of .167% annually, or one-sixth of a percentage point. (You may see the expense ratio listed elsewhere as .18%. That ratio is the gross expense ratio, and does not include any adjustments, etc.)

I’ve ignored taxes and made the assumption that smart financial planners would stick the their short term plays in a tax advantaged account.

Domestic Overexposure

And finally, while all these companies are strong, multi-national corporations, I cannot, under any circumstances, recommend a portfolio that is so heavily weighted on one stock exchange, nor recommend a portfolio of companies that do most of their business in the United States.

While I firmly believe that the United States is a great country, one in which I enjoy living in, I can’t place my retirement on its future, especially when it makes up only 30% of world output. Investors must, must, must, look overseas, and do so to an even greater extent if they’ve still many years or decades to a retirement.

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