written by reader Dogs of the Dow, Part Three: There is More Than One Way To Skin A Cat – Or Dog.

THE BLIND SQUIRREL DIARIES

By theblindsquirrel, June 30, 2014

[Ed. Note: Jim Skelton, The Blind Squirrel, writes a monthly column for us about his experience as a Financial Advisor. His topics, thoughts and opinions are his own. Enjoy!]

Greetings once again to the Gumshoe Nation! Your resident Blind Squirrel returning for June with what will be the last posting regarding the Dogs of the Dow theory of investment management. In this month’s column I am going to explore a couple variants of the process that have been more or less accepted by the general investment community as viable alternatives to the basic strategy. Variations that stay true to the underlying philosophy of buying and managing the portfolio based on yield and rebalancing once yearly, but alter a couple of the other parts of the approach in hopes of getting even better results.

Before I began that part of the discussion, I’d like to refer any new readers back to the previous two parts of this series for review. Since my columns are viewable by all visitors to the Stock Gumshoe site, you may be just now dropping by to see what’s on tap here and not have seen the previous posts on the subject of the Dogs of the Dow investment strategy and process. If that’s you, and you care to, you can see Part 1 of the series entitled “Dogs Are A Man’s Best Friend,” here. In this section you are given a historical overview of how this strategy came into being, some of the past results using it have provided, and a working base of information as to how to go about setting up an account for yourself that utilizes the strategy. Then, in Part 2, “Getting Down To Business,” you are given specific instruction on how to select the stocks for the portfolio, why investors seem to be attracted to the process, some of the psychology behind the strategy, an example of what not to do based on an actual case I had with a client in the early 1990’s, and the very important process involved in the yearly rebalancing of the portfolio. Also included in that report is a link you can open and view the actual marketing brochure I wrote (with compliance approvals) and used to present the idea to clients when I was working as an active Investment Advisor. It contains, among other things, a historical chart of performance going all the way back to 1972 – data I seriously doubt you’ll find anywhere else at all. It can be useful information for devotees of the Dow Dogs Theory. To view Part 2, click here.

That will serve to get you up to speed and ready to understand more fully what I will address today in this final part of the series, ”There Is More Than One Way To Skin A Cat – Or Dog.”

Let’s get down to business.

We humans are a curious lot. Seems we are always striving to take things one step further in an attempt to improve on whatever it may be we are looking at. And that is a very, very good thing. It’s called ”progress” and without that we’d all still be stuck thinking that the world was flat, nothing could ever replace the horse as transportation, or cooking on a spit over an open flame was the ultimate in kitchen technology. So we tinker, we alter, we ask ”what if?” And this has applied in spades to the Dogs of the Dow theory over the past 25 years or so. I’ve seen more variations on how to ”improve” the returns, or reduce the risk, or apply better standards of selection, than I can remember. Dozens, literally. But at the end of the day they all go perhaps a bridge too far and never gain any traction within the investment community overall. Something may work for the person that came up with the idea, but it has something in it, something that others just aren’t willing or capable to do, in order to run the portfolio. They seem always to take what is a basically simple process and make it complicated. We don’t like complicated as a general rule. I know I don’t. The original formula for selecting the stocks we’d own, the way we ”manage” them over the course of a year, and the method we use (here again, a simple method), to make buy/sell decisions and rebalance the portfolio has never been bested in my opinion. And that is why I stick to the original flavor. See, I’m a ”Coke Classic” kind of guy. ”New Coke” just doesn’t cut it for me.

That said, there is one – only one – variation on the original concept that has taken root and is quite popular with investors. It actually makes things even simpler than the original process while retaining all the basic underlying tenants that we use. It is the only variant I ever used with a few select clients and the only one I would consider for myself. It’s known as the ”Small Dogs” approach, and here’s how it works.

The Small Dogs
”Winning isn’t about the size of the dog in the fight. It’s about the size of the fight in the dog.”

I first encountered this concept sometime around 1995 or so. And unlike other variations on the original strategy, it caught my attention for one basic reason – it stayed true to the methodology employed in the original approach to stock selection, maintenance, and yearly realignment. Everything else I had seen changed some part of that. But all the ”Small Dog” strategy changed was the number of stocks in the portfolio. Instead of holding 10 positions, the Small Dogs holds only 5. And the way those 5 are picked from the original list of 10 is simplicity itself: one just looks at the share price of all 10, then culls out the 5 with the ”smallest” (lowest) current price. That’s it. Done. The investor decides how much total cash they want to fund the account with and spreads that evenly over these 5 stocks. At the yearly adjustment time, the new list of the top 10 yielding stocks in the DJIA is compiled, then the 5 with the lowest share price are used for adjustment to the Small Dog portfolio.

The only quirk here is that you might have bought a stock in the original Small Dogs portfolio that is still on the Top Ten list, but has since appreciated to a point where it isn’t one of the 5 lowest priced stocks on that master list. It may still be on that Master List, yes. But you will sell because it isn’t one of the 5 lowest priced. See the difference? Still on the main list but no longer something you would keep in the Small Dog portfolio. But no matter – it works out fine.

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Over the years the Small Dogs portfolio has been able, in many instances, to perform a little better that the original Dogs of the Dow. But not always. Let’s look at the first half of 2014 as example.

I maintain hypothetical tracking portfolios on another financial site to stay in touch with performance of several different portfolios. Two of these portfolios are the original Dogs of the Dow stocks and another is for the Small Dogs portfolio. In theory, I place $10,000 in each portfolio on January 2nd of each year. That’s $1000 for each of the original Dogs of the Dow portfolio stocks, and $2000 for each of the Small Dog positions. Both portfolios therefore start each year worth $10,000. Then I let those dogs run just as I would if these were actual portfolios. This gives me an accurate picture of how the portfolio is performing at any given time. I can use that data to make direct comparison between benchmarks and other portfolios. The only thing that my system cannot account for is dividends – and that is an important part of the total return on these Dogs portfolios. So I compensate by looking at the yield based on entry price and last declared quarterly dividend, then do a simple calculation to get an average yield figure. This I then use to calculate approximately how much income the portfolio would have generated year-to-date, and I add that back to the portfolio value to arrive at an approximate return percentage. It’s not a perfect system, I know. But close enough for this work.

On January 2nd, 2014, the 5 stocks that made up the Small Dogs portfolio were Cisco (CSCO) @ $22.17, General Electric (GE) @ $27.86, Intel (INTC) @ $25.78, Pfizer (PFE) @ $30.47, and ATT (T) @ $35.24. In fact, those same 5 stocks are still the 5 low priced stocks on the Dogs of the Dow Top Ten list.

As of June 25, 2014, the Small Dogs portfolio was valued at $10.482, up 4.81% not including dividends. The Original Dogs of the Dow portfolio was valued at $10.816, up 8.16% not including dividends. The average dividend yield for the Dogs of the Dow portfolio on January 2, 2014 was 3.44%. Divide that by half to account for 2 quarters of payments and you have 1.72%. Multiply 1.72% by the $10,000 investment and you have income of ~$172 to add to the return. This would then give you a value of $10,654 (6.54% total return) for the Small Dogs and $10,988 (9.88% total return) for the Dogs of the Dow original portfolio.

As I said, I know this is an imperfect calculation for the total return including dividends. But it is close enough to let us evaluate the relative returns of the two portfolios against one another and the appropriate benchmark of the DJIA 30. For the first half of 2014, the Small Dogs are doing quite nicely, but the Dogs of the Dow Top Ten are taking names and kicking butt. Year to date, the DJIA is up 1.46 % – it began the year at 16,576 and closed today (6/25) at 16,818. Relative to that, both portfolios would have to be thought of as performing extremely well!

Do The Small Dogs Win The Fight?

The best answer to this important question is … maybe. There are years when they beat the original Top Ten, and years when they don’t. And importantly, there are years when the market is down that they substantially underperform to the down side as shown under the year 2008 below. That means more risk of loss, never a good thing. An investor needs to take that into consideration when evaluating the idea of using the Small Dogs approach. Consider the following table of returns from the website DogsOfTheDow.com

Average Annual Return Investment

2006 2007 2008 2009 2010 2011 1 yr 3 yr 5 yr 10 yr 20 yr
Dogs of the Dow 30.3% 2.2% -38.8% 16.9% 20.5% 16.3% 16.3% 17.9% 3.4% 6.7% 10.8%
Small Dogs 42.0% 4.2% -49.1% 19.3% 15.4% 19.2% 19.2% 18.0% 1.8% 7.7% 12.5%

Why would this be so, I wonder? This is a question I’ve never been able to answer to my own satisfaction. Some say it’s the result of that widely-held belief that contends the lower the price of a stock, the easier it is for the price to rise faster and further than more expensive ones. And I have to admit that at times this does seem to be the case. But this isn’t supported by rational and logical thought. Stock prices should rise or fall based on the underlying fundamentals such as earnings, P/E ratios, revenue growth, etc. Perhaps it is due to that low price finding a way forward faster than one higher priced. When all is said and done, it really doesn’t matter why – the Small Dogs have the advantage over longer periods of investment.

The website does not have results posted for 2012 or 2013, but this is a good enough sample for us to gain insight. The Small Dogs have a better record at times and a worse one at others. Long term, the Small Dogs have the advantage with a 20 year average annual total return of 12.5% vs. 10.8% for the Top Ten.

Other than this ”Small Dog” variation of the strategy, I really don’t have any other approach that I want to delve into at this time. It would just confuse the issue. If you have a variation that you can demonstrate generates superior returns and can be verified by means of back testing, and is relatively simple to implement, I, and I’m sure other readers, would like to hear from you about it. That’s one of the true beauties of the Stock Gumshoe website – the ability for readers, Irregulars (paid members) or not, to respond and communicate directly with the columnists here and get responses, not only from them but from other investors that are also interested. Try that on any other site. I doubt you’ll find a more user-friendly financial site anywhere.

If I may say so once again, Stock Gumshoe is truly a one-of-a-kind place for investors to gain all sorts of knowledge and information, and exchange same freely with one another in a respectful manner. Consider that, and become a site member, an ”Irregular” as the Chief-Gumshoe-in-Charge, Travis Johnson (site founder and CEO), calls them. It’s only $49 bucks a year – and what Travis alone shares on a near-daily basis by ”un-teasing” the ideas other financial newsletter publishers send out and then want you to pay hundreds, indeed at times thousands, of dollars to learn what stock they are recommending. Travis uses his ”Mighty, Mighty Thinkolator” to uncover the identity of the stock and then provides a thoughtful and in-depth overview of the company to boot. It must make those guys and gals at places such as the Motley Fool, Stansbury & Assoc., et al, totally nuts to see their ideas being so easily and accurately revealed. And at no cost or obligation on the part of our readers. Pretty astounding when you think about it!
Note – No, I’m not paid to say that. Not a penny. Never even been asked to express my thoughts on the subject. It’s just that I happen to be one of those people who, when he finds something of true worth and value, likes to share the idea with others and isn’t shy about doing so. This site fits that bill. Consider yourself as having just been shared :0)! Now, when done reading this article, find the place on the home page where you can get signed up as an Irregular and JUST. DO. IT.

[Ed. Note: Aw, shucks, thanks, Jim. Well, if you insist…free members can upgrade here.]

Better get back on track now before I wander too far afield from the subject at hand. I’m prone to those little asides on occasion. Let’s see here, where was I … ?
Oh Yeah – The Dogs of the Dow portfolio strategies and related matters.

ETF’S, ETN’S, and Other Ways to Invest In The Strategy

At this point in the discussion I’m going to segue from talking about variations in the strategy itself and into a look at some of the different ways you can choose among to get the strategy up and running for yourself.

I’m going to assume you already know what an ETF (Exchange Traded Fund) and ETN (Exchange Traded Note) are. But in case you aren’t sure, they are portfolios made available for investment by various brokerage houses that contain a specific set of investments geared toward a particular area of investing. These selected positions, which can be equities, debt instruments, or hybrids of these, are wrapped into the ETF/ETN and trade daily on the exchanges just like a single stock. You can buy or sell at any moment at the current bid/ask price. And there are quite a few that are available that contain the Dogs of the Dow stocks and in general operate under the rules of the strategy. An investor who wants exposure to this portfolio with even less effort can simply buy shares of the ETF and let the managers take care of all else.

But there is a price to be paid for all this convenience. In addition to whatever sales commission your broker charges, there are internal management fees that are assessed against the portfolio. These generally run between 0.35% to 1.00% annually. That cuts into and reduces your return. Over time this can add up to more than what a little number like those seem to represent. Also, the investor doesn’t have total control of the portfolio as they do if they own the individual stocks and run it for themselves. If it should happen that one of the portfolio positions is well and truly going into the tank and ought be cut loose before a bad situation could get a lot worse (for example, a major reduction in the dividend, or being taken out of the DJIA by the people at Dow Jones & Company that are responsible for making those periodic adjustments) the investor in the ETF has only one choice, and it’s not a good one. She must either hold on and ride that storm, or sell everything and close the entire investment. The proverbial rock and a hard place decision, so to speak. The investor that has his account set up and is holding the individual stocks can zero in on the problem child and shed it alone, leaving the rest in place and intact. A much better choice to have, wouldn’t you agree?

With that said, a reminder: Making adjustments to the portfolio outside the ones called for by the strategy is not recommended. In the 20 some years I used the process with clients, there were only two instances I felt were of serious enough potential consequence to warrant stepping in and making a change. Resist the urge to do that, to make changes based on some new report or unfavorable news. Take the emotion out of the equation and let the process work as it is supposed to do.

Now, I know you are curious as to what those two situations were that caused me to get on the phone with clients and recommend making a change that didn’t align with the strategy. So I’ll tell you about one in detail, the other in general. That way you will see what I mean when I say the situation must be dire, not simply unsettling.

The first case happened in late 1992 as best I recall. I had been using the Dogs of the Dow strategy with clients for about a year and had maybe one dozen or so accounts established. The list of stocks in the top ten was headed by a company called Woolworth’s, an old-line retailer commonly referred to as a ”five and dime” store. That came from the idea that most goods sold there when the stores were first opening in the late 1890’s and early 1900’s cost from a nickel to a dime. These were ”sundry” or ”notions” stores where a housewife could get most anything she needed to keep the household running smoothly, especially in the areas of bolt cloths and all the things needed to make and repair the family’s clothing. After 100 or so years of operations, these stores (J.J. Newberry was the other main player still standing in that space) were under tremendous pressure by the likes of Sears, J.C. Penny, and that upstart company out of Arkansas, Wal-Mart, to change or die. And they seemed incapable of change.

Woolworths was the number one company on the top ten list due to a nice dividend and a serious decline in price over the previous year or so. Quite frankly, I didn’t like the idea of owning the company at any price, but following the discipline of the Dogs I had no choice. So all clients owned it as a part of the portfolio. One fine morning I walked into the office, took my seat and opened my WSJ to see a bold headline that announced Woolworth’s board had met the previous evening and cut the dividend by 50%! Oh boy. What a way to start the day. A cut of maybe 10% is cause for concern – but a cut of 50%? That goes way past mere concern. That gets into fire drill territory.

I sat and absorbed the impact I knew would happen to the stock price when the market opened at 10:00 AM, a couple hours yet away. I remembered a study I had seen some years before that looked at the impact a dividend cut had on stock price, and also on the likelihood of additional cuts. I remembered that this study concluded by saying a cut of over 25% was in all probability precursor to additional cuts coming soon. Which could only mean additional declines in stock price. I had a decision to make. An important one, not just for the sake of perhaps stopping the possibility of future price declines in Woolworth’s stock, but for how I would manage these Dog portfolios in the future and the impact that could have on my own commitment and credibility with clients. Remember, I had come down hard on the idea of a ”hands off” approach to the portfolio during the time between the annual rebalancing. And I was now pondering violating that concept myself. What would that say to clients, what would it do to their commitment to the system if they got concerned about a company they owned and wanted to get out?

After maybe 15 minutes of checking all other news sources I had access to and thinking over my choices, I decided this was an instance where being proactive was justified. I began to call clients that were using the strategy, telling them what had happened, and asking they allow me to sell their shares on the open. Each and every one gave me that permissions, so at 10:00 am the tickets were all dropped and the sales were made. It wasn’t pretty – but we were out. The proceeds were used to buy whatever stock had been in the number 11 slot at that time.

A quarter passed, the stock price fumbled and bumbled around, never improving, and the board met again. This time, they did just what I was afraid they might have to do – they totally eliminated the dividend. Share price tanked, of course, and Woolworth’s was down for the count. All that remained was for someone to write the eulogy and bury that blast from the past. It’s change and adapt, or die in Capitalistic economies. Woolworth’s was unable to change. So they died.

I’m not proposing any sort of genius on my part in this decision. Yes, it saved clients some money to be sure. But I would have much rather it never happened so I didn’t have to violate the way the strategy is supposed to operate. I vowed to always be as totally sure as I could be that a change was absolutely necessary before making those kind of calls to clients again.

The only other time I had to make a decisions was when the Board of Directors at Dow Jones & Company made some changes to the composition of the DJIA, and in so doing dropped from the index one of the stocks we held. I decided it best to go ahead and sell that company – we’d be doing it at rebalancing time anyway – and replace with the next stock that fit the requirements. Not a big deal, really. But it was the last time I ever made a change to the portfolios based on what I thought was best instead of just letting the story play out as proscribed. I tell you these two little stories to emphasize the level of commitment you need to have to stay the course and not interfere with the process.

Now back to the discussion of using ETF’s and such.

I covered all the disadvantages that I see in using the ETF format as the vehicle of choice in Part 1 and Part 2 of this series, so I’m not going to ride that horse again. You should know by now I am a committed and dedicated proponent of owning the individual stocks outright. Even so, I know there are some who, due to time constraints, knowledge, or basic disinterest in the process, still seek that total simplicity the ETF offers, and who am I to say what is right for you? That said, here’s one example of an ETN for you to consider. Note: this is not a recommendation or endorsement by me of this particular ETN. It’s just one that I’ve seen referred several times in other venues and have some current research available and at hand.

Elements Dogs Of The Dow Total Return Index Note (DOD)

DOD is an Exchange Traded Note that follows the Dogs of the Dow investment strategy. It’s stated investment objective is: ”The investment seeks to replicate, net of expenses, the Dow Jones High Yield Select 10 Total Return Index. The Index tracks the stocks with the highest dividend yield in Dow Jones Industrial Average.” It has a net expense ratio of 0.75%As of June 25, 2014, the last 52-week price performance was +19.70% and the closing price was $14.92 per share. For the 5 years ending April 25, 2014, the cumulative total return (including dividends) of DOD was 183.3% vs. a total return for the SPDR S&P 500 (SPY) ETF of 138.1%. A rather sound trouncing of the benchmark for this time frame.

Note must be made of the fact that ETN’s have both a NAV (Net Asset Value), which is the true value of the underlying positions in the portfolio, and the actual trading price. These two valuations can and do differ in relation to one another. The NAV of DOD was $14.91 on June 25, 2014 vs. the closing price of $14.92 per share. Net assets under management as of April 30, 2014 (the last date this number was reported) was $26.2M. Inception date is November 07, 2007. The ETN is sponsored by Deutsche Bank AG / ELEMENTS ETN’s and has the legal structure of being a Senior, Unsecured, Unsubordinated Debt instrument.

Unfortunately, certain data points that I would like to know are not given in the available research. For example, under Distribution Yield there is no entry. No list of the basket holdings is shown so I can’t be sure exactly which stocks are held. Under the heading of ”Annual Turnover Ratio” the entry reads ”0”. This would imply no trades being made within the portfolio, which leads to questions about rebalancing and following the Dow Dogs buy/sell discipline. So many questions, so little information. And under the heading ”Investment Philosophy” the entry reads simply ”Enhanced Strategy.” What, exactly, is meant by ”Enhanced?” I know it is not a leveraged portfolio, nor does it use options of any type. So what is this reference to being ”enhanced?” One wonders – and I’d have to know with more certainty before I, personally, would be willing to commit my cash to it. Perhaps the prospectus, something I do not have at hand, would shed more light on these questions.
Source: Fidelity Investments Research Key Statistics and MarketWatch article released May 5, 2014, entitled ”Hot ’dividend dogs’ take world stocks by the tail.”

I could continue here, building you a long list of similar ETF’s from differing Sponsors. Seems to me that this would be an unending process with no particular benefit. If you want to use this ETF format as your vehicle of choice, just go to your brokerage firm’s research hub and enter something like ”Dogs of the Dow ETF’s.” That should get you a list of the products they offer for you to choose from. Just don’t expect there to be much difference one from another. If they are staying true to the strategy and not employing leverage, options, or other techniques to try and improve returns, there is little reason beyond internal management fees for the results to differ by much. If you do run across one that has substantially better net returns, look carefully before you leap. There has to be a reason for this outperformance, and that reason may translate into not only a better total return number but also a much higher risk factor. Mr. Market does not provide us free lunches.

In case you may be wondering if there is a mutual fund that employs the Dogs of the Dow process, the answer is no. There can’t be. By definition, a mutual fund offers investors a certain level of diversification to potentially reduce risk somewhat. The SEC set a minimum limit of 30 positions that a portfolio must contain in order to qualify as a mutual fund. And since the Dogs of the Dow has only 10 positions, it could never be classified and used as a mutual fund offering. I have seen a couple variable annuities that offered the Dogs of the Dow strategy as an investment option within the annuity. Given the additional complexities of annuities in general, I normally don’t think of them as being a way to use the process. But that depends on the needs and wants of each individual investor, so I suppose it could be used if suitable and appropriate.

Summing Up – Are Dogs Really A Man’s (Or Woman’s) Best Friend?

I suspect it is more than apparent by now, I am a believer in the Dogs of the Dow investment strategy as one way to manage a part of an overall investment program. Note I say ”a part of”, not ”all of.” That is a key takeaway from these past three articles on the subject. The Dogs gives an investor a logical and disciplined way to manage a portfolio of large cap value stocks. It forces him to use the contrarian approach to buying – going against current conventional wisdom, not running with the crowd. And, unlike many other approaches, it not only tells you what to buy and when, it also has a disciplined structure for when and what to sell – a key ingredient that is often lacking in other methods. Several legendary investors such as Sir John Templeton trumpeted this method of investing – contrarian investing, that is – not the Dogs of the Dow specifically – with great success. It takes patience and discipline to follow, but the rewards can be bountiful. When used as part of a mix that could also include growth stocks, momentum stocks, and high-income instruments, it can provide a certain balance within the overall portfolio and help smooth out the ride over time.

So are dogs a man’s best friend? To my mind, yes, they are. Now it’s your turn to decide. Could adding this into your mix prove beneficial? Only you can answer that.

Time now to put a bow on this month’s edition of The Blind Squirrels Diaries, send up to Travis at Gumshoe HQ for his OK, then have his trusty assistant, Lynn (someone you will never hear from but is the person that makes me and other writers here look to be better than we really are with grammar, spelling and such) and then hopefully get published before June becomes July.

And speaking of July, the 4th is just around the corner. I wish all of you a great time on this very special holiday, the day we celebrate our Independence and Freedom. When at a backyard BBQ with friends and family, or tailgating at a sporting event, or just taking it easy for a day, please take a moment to remember our brave men and women serving far from home, providing us with that blanket of protection and preserving those freedoms and liberties we so often take for granted. God bless them one and all and keep them from harm’s way. Remember them, and the many that came before. We owe who we are and all we have to the sacrifices they make every day on our behalf.

Until next time, may the best of investment success come your way, and remember: ”Even a Blind Squirrel finds an acorn every now and then”

Jim Skelton
The Blind Squirrel


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Slick Rick
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Slick Rick
June 30, 2014 11:58 am

Very informative article ………Thank You!

George
Member
George
June 30, 2014 7:58 pm

Out of curiosity, how do the sharpe ratios of the Dow, Dogs of the Dow and Small Dogs compare? Despite the increased return of the Dogs and Small dogs, does increased variability hurt the ratio?

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George
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George
June 30, 2014 8:27 pm
Reply to  Jim Skelton

Its not a way to run or manage the portfolio, but a measure of whether you should invest in it. If the sharpe ratio is poorer, then it would be better to buy the dow or such with leverage to get better returns for the same risk (ex. a combination of leveraged and unleveraged etfs to beat the dogs returns with less/same risk) … or simply select a better investment vehicle. If the dogs consistently have a better sharpe ratio, then its a real dow replacement.

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hipockets
Irregular
June 30, 2014 11:53 pm

Great wrap-up, Jim. Thank you. And thanks to the lovely lady Lynn, who keeps everyone up to snuff.

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