Different Takes on “Dogs of the Dow”—Part TwoAdvice to the Advisor
The long-time appeal of the “Dogs of the Dow” concept, Gordon Scott of investopedia.com postulates, is that “it presents a straightforward formula approach.” Out of the 30 stocks that make up the Dow Jones Industrial Average, investors, at the start of each year, select those ten with the highest dividend yield. Based on the principle that the dividend payout can be used as a measure of the average worth of the company, a high yield is seen as signaling that the company is near the bottom of its business cycle.
An offshoot of “Dogs of the Dow” is Sheaff Brock’s “Bulls of the Dow” strategy. Both are designed for growth while offering income from dividends. However, investment advisors should take note of two highly significant differences between the two strategies:
- The selection of the ten “Dogs of the Dow” stocks takes place after the stock market closes on the last day of the calendar year. The strategy, then, involves investing an equal dollar amount in each of the ten stocks, holding that portfolio for the entire year to come. In contrast, the “Bulls of the Dow” strategy is rebalanced on a quarterly basis.
- “Bulls” selections are based, not on the dividend ratios, but on each company’s downside risk scores. Fully 22 different factors are measured, including:
- free cash flow
- earnings growth
- analyst revisions
In fact, as Managing Director Dave Gilreath explains, in portfolio selection, Sheaff Brock advocates erring on the side of caution, focusing on analyzing and managing downside risk. One of the numerous tools Sheaff Brock employs is Revelation Investment Research, Inc.’s Downside Risk report, or DRA, which is based on the premise that avoiding losers can be as important to portfolio performance as finding winners. In contrast with the “Dogs of the Dow” strategy (which selects the 10 stocks based on dividend payout alone), “Bulls of the Dow” managers consider trading volume, new equity issued by the company, and debt levels, along with general factors in the U.S. and global economies.
Downside risk is “an estimation of a security’s potential to suffer a decline in value if the market conditions change” (Investopedia), and measures are “one-sided,” with no consideration of upside potential. “The classic investing assumption is that higher risk means higher expected returns,” Gilreath observes. “But downside risk research by Revelation Investment Research, an institutional equities research firm, shows conclusively that the long-term reality is quite the opposite: lower risk means higher returns.”
Like managers of a well-run football team, portfolio managers should consider offering long-term investors both offensive and defensive strategies, and that is precisely what the “Bulls of the Dow” strategy aims to do.