Those Dangerous Dogs of the Dow

Dogs, Dogs, Dogs

The Dogs of the Dow. It has such a nice ring to it doesn’t it? Almost everybody who has been around investing for a while has some understanding of what that phrase means. It’s quite possibly the most famous of all dividend investing strategies having been popularised by Michael O’Higgins in a 1991 book called ‘Beating the Dow’. So the trick goes, by investing in the 10 highest yielding stocks in the Dow Jones index once per year for a whole year you could beat the Dow, and with it probably the majority of most active fund managers. To top it all the Dogs of the Dow backtest worked extremely well; beating the market by almost 4% a year over about 20 years. But investors who do throw money into high dividend yield strategies have often found the reality much harder going… the truth is that high yielding stocks may well be the finance equivalent of surgery enhanced middle aged women. They might look pretty at a stretch, but you may well be disappointed when you take them home.

Putting dogs to work

Firstly its worth understanding why high yield strategies ought to work, and the why rests predominantly on investor over-reaction. Dividend investors prize certainty over everything else. Pension funds are under pressure to pay out a constant stream of income and need their investments to bear expected fruit. So whenever a stock looks to be at risk of suffering from a dividend cut or under business pressure a large group of shareholders start to ask questions… “where will the yield end up?”, “how big will the cut be?”,“will these problems continue?”… as a result many will often sell regardless of price and reinvest in safer more certain waters.

But these worries often drive prices down too low for the risk, providing opportunity for canny contrarians. Even if a dividend cut does occur, you may well end up getting a half-decent yield after all, but more importantly you can end up with a nice capital return to boot as the uncertainty surrounding the stock dissipates. So buying high yielding stocks can give you two bangs for your buck.

Man's best friend?

So there are certainly some good behavioural reasons why a high yield strategy can make sense and at first glance the record seems to back it up. Tweedy Browne published a paper titled “The High Dividend Yield Advantage” which summarised a whole ream of studies illustrating that high yielding stocks beat the market quite substantially over the long term. One study byCapel Cure that was specifically UK focused showed that over 35 years up until 1988 the highest yielding stocks in the market outperformed the lowest yielding stocks by almost 6% annually, while Jeremy Siegel, author of The Future for Investors, found that the highest yielding quintile of stocks outperformed the S&P 500 by 3% annually over an almost 50 year period up until 2002. This is even more pronounced when comparing countries - the highest yielding country indices outperforming the lowest yielding countries by an astonishing 12.8% annually from 1969 to 1989.

But while the evidence backing these strategyies is substantial, a contrarian voice has been heard in the very renowned academic Ken French. He discovered that high yield stocks have very variable returns depending on the decade chosen. In some decades the highest yielders actually underperformed the lowest yielders (for example in the seventies or 90s). It appears that during inflationary periods or periods of rising interest rates high yield stocks can behave much more like bonds and lose value.

Sick as a dog

To continue the cautionary note, according to Aswath Damadoran in his book “Investment Fables” there are several reasons why the highest yielding stocks may not make good pets for investors: namely dividend cuts, slower growth rates and higher tax costs.

Firstly on dividend cuts: high yield stocks are priced as bargains for a reason - the market thinks the company is in trouble and is worried that the dividend can’t be sustained or may be cut. Often, in the highest yielding segment of the market at least half the stocks will be paying more in dividends than they make in profits, if they make profits at all. Intuitively one would expect that these stocks would be the most susceptible to dividend cuts, and the evidence does seem to back this up. Three of the studies quoted in the Tweedy Browne paper found that the very best returns were not produced by the highest yielding segment of stocks, but rather by the second highest yielding segment (whether by decile or quintile).

Recent Soc Gen research backs this up - the higher you reach for yield, the less likely you are actually going to receive the full amount - i.e. the realised yield is far less than the forecasted yield. It seems that reaching beyond a yield of 8 or 9% is not going to pay any further dividends, it’s actually more likely that you’ll receive less.

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Secondly on lower growth rates: high yield stocks are likely to be paying out a much higher proportion of their profits to sustain their dividends. This means less cash is available to reinvest in the business which is likely to lower the future growth rate of the company. Eastman Kodak may have once been a prized dividend dog, but investing in that business lost you 100% of your money due to the move to digital photography - growth and business sustainability are clearly a key issue for dividend investors. David Dreman showed in his book Contrarian Investment Strategies that the primary reason why the highest yielding segment of the market underperformed was due to lower share price gains, possibly due to the expectations for future dividend growth rates.

Thirdly - beware tax costs: This really is the big one. You can only spend what you get to keep after taxes. While the studies quoted in the Tweedy Browne paper show amazing charts of wealth accumulation over the long term from high yield dividend reinvestment strategies these are all printed before tax. If income taxes are substantially higher than capital gains taxes the edge provided by high dividend yield strategies can be completely consumed by tax. In fact, Damadoran illustrates that high-yield strategies in the US actually underperformed half-yield strategies over the last century once taxes were taken into account while a pair of academic research papers have debunked the ‘Dogs of the Dow Myth’ once risk and taxes are taken into account. The US has now changed its tax legislation so that dividends are taxed more favorably - on an equivalent basis (15%) as capital gains - but many investors in the UK still suffer from this ‘dividend disadvantage’ as higher taxes are applied to income. So beware!

Teaching old dogs new tricks

So we’ve certainly thrown some cold water over the kennel, but these barking puppies will continue to have a certain attraction for retired investors who love income. I believe the great disservice that O’Higgins did for investors is to encourage them to look primarily at the list of highest yielding stocks without filtering for dividend sustainability and growth. In the 80s and 90s Dow Jones index stocks were extremely stable, but these days with the disruptive nature of internet competitors and tough credit markets the giants of yesterday are more at risk than ever before.

While Our Dividend Dogs of the FTSE strategy has performed admirably since we started tracking it last December, a more modern approach that applies filters for company ‘quality’ and credit risk to high yielding names may be more profitable in the long run. A couple of weeks ago I highlighted a modern ‘Quality Income’ strategy that uses the Piotroski F-Score as a measure of financial health which we are now modelling as a screening strategy. Damadoran though suggests a more traditional approach to finding sustainable high yielders: He suggests a set of screening rules as follows: dividend yields greater than twice 10 year government bond rates, dividend payout ratios that are less than 60% of earnings, dividends less than current free cashflow and an expected profit growth of more than 4% annually for the coming 5 years.