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.

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 y