Stock picks for the new tax laws

In last month's column, we discussed how the new tax law gives investors a powerful incentive to seek out stocks in sound companies that pay generous dividends.

Marvin Appel, PhD, and Brian Hufford, CPA

In last month's column, we discussed how the new tax law gives investors a powerful incentive to seek out stocks in sound companies that pay generous dividends. Here we examine a stock selection strategy that has had an excellent record over many years, both historically and in real time: The Dogs of the Dow.

Buy high-yielding, blue chip stocks

The Dow Jones Industrial Average is one of the best-known barometers of the U.S. stock market. It consists of 30 large U.S. companies selected to provide a cross section of the U.S. economy. The "Dogs of the Dow" are the 10 stocks out of these 30 that have the highest dividend yields. (Dividend yield is the annual dividend payout of a stock divided by its price.) As a group, these stocks are assumed to be available at attractive prices.

Implementing the strategy is simple. At the end of each year, find the 10 stocks out of the thirty in the Dow Industrials with the highest dividend yields. This information is available in a variety of sources, most conveniently on a Web site dedicated to this strategy, www.dogsofthedow.com. Buy equal dollar amounts of each of the 10 stocks. So, for example, if you have $20,000 to invest, you would buy $2,000 in each of the 10 highest-yielding Dow stocks. (I do not recommend implementing this strategy with less than $20,000 because even at discount online brokerages your commission costs would become too high.)

You then hold these 10 stocks for the entire year. At the year's end, you select the 10 new stocks from the Dow Industrials and rebalance your portfolio among these new Dogs, planning to hold them for the upcoming year. Most of the 10 stocks in the portfolio will likely remain in place from one year to the next.

The system requires only a small amount of effort once each year. Yet it has outperformed the Dow Industrial Average over the long term and has done so with less risk. Since 1957, the Dogs of the Dow have returned a compounded average of 14.3 percent including dividends, compared to 11 percent for the Dow Industrials.

Not only have the returns been better, but the risk also has been lower. During 2000 through 2002, the Dogs of the Dow strategy lost almost 8 percent, while the complete Dow Jones Industrial Average lost more than 23 percent. During the two years from 1973 to 1974, the Dow Industrials lost 33 percent, while the Dogs of the Dow actually gained 2.6 percent. 1977 and 1981 were two more years in which the Dow Industrials lost while the Dogs gained. It is important to hold all or most of the indicated stocks when implementing this type of strategy, because in the past individual stocks within the Dogs have frequently lost significant value.

Of course, this has not been a one-way street. In 1990, the Dogs lost almost 8 percent while the Dow Industrials lost less than 1 percent. Furthermore, during many bull market periods, the Dogs of the Dow strategy (along with other value stock strategies) has underperformed the broader market. The most recent stretch of Dog underperformance was the four years between 1996 through 1999.

Note that none of the performance results above take into account taxes or transaction costs, or slippage due to trading delays.

It is unnecessary to enact this strategy exactly on December 31. Although historical results assume that investment date, in theory any day should suffice. In fact, you may get better prices on your transactions if you act on a different day by avoiding the potential crunch arising from most others following this strategy. Also, during years when you might have to realize capital gains, you should hold winning stocks one day beyond a year to qualify for the more favorable long-term capital gains rate.

Current Dogs of the Dow selections

For those of you interested in starting a portfolio from scratch, the current 10 components of the Dow Industrials with the highest yields (as of October 3, 2003) are Altria, SBC Communications, General Motors, AT&T, JP Morgan Chase, DuPont, Citigroup, Merck, Honeywell, and ExxonMobil. The current dividend yield for this group is 3.9 percent, compared to 2.2 percent for the entire Dow Jones Industrial Average.

Dr. Marvin Appel is CEO of Appel Asset Management. He holds a degree in biochemical sciences from Harvard College and earned his MD in 1991. He is coauthor of Systems and Forecasts. Contact him at (516) 487-7146 or mappel@appelasset.com. Brian C. Hufford, CPA, CFP, is president of Hufford Investment Advisory Programs, LLC, and Hufford Financial Advisors, companies dedicated solely to helping dentists secure solid financial planning and safe investment strategies. He can be reached at (317) 848-4987.

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