Will 'Dogs of the Dow' Become Best in Show?

January 3, 2005; Page C1

Even junkyard dogs turn tail and run when drug problems and financial scandals move into the neighborhood.

The "Dogs of the Dow" -- the 10 stocks with the highest dividend yields in the 30-stock Dow Jones Industrial Average -- broke a three-year winning streak last year and failed to beat the total returns, with dividends, of the blue-chip average. Blame Vioxx-challenged drug maker Merck and financial-services titan Citigroup, among others. But next year, as the trend of more companies paying higher dividends continues, the mutts should get some bite to go along with their bark, say dog watchers.

"You've had some disasters that make it look worse than it really is," says Neil Hennessy, who oversees $1.2 billion in the Hennessy Funds, about the dogs' returns last year. Mr. Hennessy, based in Novato, Calif., manages money using a theory that recommends owning the Dogs of the Dow.

Typically, the Dogs of the Dow for any given year are stocks that have declined in the previous year. That's because the drop in the share price sends the dividend yield -- dividend divided by stock price -- higher. Some Dogs of the Dow theorists favor investing in the five highest-yielding stocks, others favor the broader bottom 10. Investors buying the dogs would want those high yields to fall over the next 12 months, assuming the dividends stay constant, because it would mean their share prices had climbed.

In 2004, the dogs suffered from sharp drops among three stocks: A 30% skid by drug maker Merck, a 25% fall by General Motors and an almost 1% slip by Citigroup, which was hurt by news of regulatory violations in Japan.

The dogs had an average dividend yield by the end of 2004 of 3.8%, the same as it was at the end of 2003, according to WSJ Market Data Group, which refers to the dogs as the Dow 10. Total average returns, including dividends, for the Dow 10 in 2004 were 4.5%, compared with 5.31% for the Dow industrials.

"When Merck gets hit, it really takes the life out of the Dogs of the Dow," Mr. Hennessy says. "It's tough for the other nine stocks to overcome something like that."

Like many investing strategies, the more people who know about theories and market anomalies such as the Dogs of the Dow, the more difficult it can be for these theories and strategies to outperform. Investors identify stocks earlier, for example, throwing off pricing and timing factors required for the theories to work. The traditional dogs are established at the beginning of each year, but those anticipating the strategy may begin investing in the expected dogs earlier.

The new pack of dogs to invest in for 2005, based on the WSJ Market Data Group information, is almost identical to last year's, except for the addition of Pfizer and Coca-Cola and the exit of General Electric and Eastman Kodak, which was removed last year from the Dow industrials. SBC Communications tops the list for 2005 with a dividend yield of 5%, up from 4.8% at the end of 2003. (Dow Jones Indexes calculate the Dow 10 as of Dec. 29; based on Dec. 31 numbers, GE would have just edged out Coca-Cola for the 10th spot.)

The 2005 dogs are, in descending dividend-yield order: SBC; General Motors; cigarette maker Altria Group; Merck; Verizon Communications; J.P. Morgan Chase; Citigroup; DuPont; Pfizer; and Coca-Cola.

This year will be better for dividend-focused investing theories, say investors and dog watchers. More than half of the companies in the S&P 500 will increase their dividend payments, while others will pay dividends for the first time, according to estimates by Standard & Poor's Equity Research. According to S&P's data collected up to Dec. 20, 376 of the S&P 500 pay cash dividends, compared with 351 at the end of 2002, when, S&P says, the turnaround in paying dividends began. The average dividend-rate increase in 2004 was 20.4%, helped by a Microsoft's special-dividend payment of $32.6 billion.

With the elimination of double-taxation on dividends in 2003, more shareholders have been asking their companies to pay out dividends, which are taxed at the individual level at a maximum of just 15%, notes Joseph Lisanti, author of S&P's investment-advisory newsletter, the Outlook, and co-author of the 1998 book "The Dividend Rich Investor."

"How do you keep shareholders when the markets are just struggling along? Pay them dividends," he says.

Mr. Lisanti works with S&P to compile another list with a snappy name: the DividendAristocrats. Unlike the Dogs of the Dow, which Mr. Lisanti says is "a mechanical technique" of investing, the Aristocrats list recommends stocks that have increased their dividends in each of the past 25 years. The Aristocrats, which tend to be in the consumer-staples, discretionary, health-care and financial sectors, typically pay steadily growing dividend yields that compensate long-term investors for swings in share price.

"The yield might look chintzy, but a long-term investor can get double-digit percentage yields on their fixed cost of investment over time," Mr. Lisanti says.

The S&P 500's 58 Aristocrats include Procter & Gamble, Target and newly added State Street. Among the Aristocrats are also some of the die-hard Dogs of the Dow: Altria Group and Merck.

Indeed, lack of turnover is one of the drawbacks of the Dogs of the Dow approach. The same stocks landing in the doghouse year after year means they either have significantly boosted their dividends or, more likely, their stock prices have fallen, which isn't what most investors in this strategy want.

Over the years, more technology and telecommunications stocks, which typically don't pay dividends, have joined the Dow Jones Industrial Average, while some regular dividend-paying stocks have left. As a result, "you're only ever looking at about 15 stocks in the Dow each year," says Charles Carlson, who publishes an investment newsletter called Dow Theory Forecasts and advocates a theory that buys only the most underpriced Dow stocks each year.

"If you're trying to use a theory to beat the index by only investing in the stocks of the index, then you have to have a metric that's applicable to all stocks in measuring their popularity with investors," says Mr. Carlson, whose list of 10 "Dow Underdogs" for 2005 include some of the Dogs of the Dow, along with 3M, Alcoa, Hewlett-Packard, Intel and Microsoft. Last year's underdogs lagged behind the index slightly. "The problem child was Merck," Mr. Carlson says.

Write to Karen Richardson at karen.richardson@awsj.com