A Dogs of the Dow Strategy That Actually Works: PFE, VZ, T, GE, INTC, HPQ, JNJ, MRK in Focus

It's that time of year again, for investors (and even non-investors) to assess what they didn't like about 2012, and resolve to change that in 2013. It's also the time of year investors start to think about calendar-based strategies like the Dogs of the Dow theory, putting picks like AT&T Inc. (NYSE:T), Verizon Communications Inc. (NYSE:VZ), and Pfizer Inc. (NYSE:PFE) on investors' radars. Those three names usually make each year's 'Dogs of the Dow' list because their dividend yields are three the ten highest dividend yields among the Dow's 30 stocks; the Dog strategy suggests owning [presumably at the beginning of a new year] the ten highest-yield names in the DJIA, rather than all thirty of its constituents. The theory is, those ten stocks are relatively undervalued, and therefore are more likely to outpace the Dow Jones Average's return.

There's just one problem with the approach - it doesn't work all that well.

To be fair, the theory does have its moments. In 2011, the Dow's ten dogs returned 16.3%, versus the DJIA's return of 8.4%. In 2012, however (through Friday the 28th), the dogs collectively trailed the benchmark index; Dan Caplinger over at the Motley Fool explains why. Thing is, there are almost as many 2012-like lulls as there are 2011-like victories. The end result is a very, very modest edge by using the strategy over time.

The Dogs of the Dow website reports that for the past 20 years, the ten highest-yielding Dow stocks collectively returned an average of 10.8% per year. Problem: Over the same 20 years, the Dow Jones Industrial Average itself has also returned an average of 10.8% per year. For the past ten years, the Dogs strategy has averaged a return of 6.7%, topping the Dow's 6.1%. For the past five years, however, the Dogs of the Dow theory has only produced annual gains of 3.4%, compared to 4.4% for the Dow Jones Industrial Average itself.

The outperformance of the tactic isn't all that significant, nor consistent, leaving one to wonder if it's worth the trouble.

There's a twist on the idea, however, that may well be worth the time and effort, and still leave you with blue chip names like Pfizer, AT&T, and Verizon Communications.

It's called the Small Dogs (of the Dow) theory, and works basically the same way as the regular dogs approach. The key difference is, rather than owning the ten highest-yielding stocks in the Dow, you just own the five lowest-priced stocks within that group of ten high-dividend names. [There's some debate here as to the approach the Dogs' creator intended with Small Dogs strategy. Contrary to popular belief, the five stocks that make up this basket are not necessarily the highest-dividend-yielding stocks that make up the Dow. These stocks are intended to be the five lowest-priced stocks of the ten that are official 'Dogs' in any given year. The idea is that low priced shares have an easier time making (relatively) bigger gains that high-priced shares do.]

The Small Dogs theory holds water too. For the past 20 years, the small dogs have outpaced the DJIA with an average annual return of 12.5% (versus 10.8% for the Dow itself). Over the past ten year, the Small Dogs have posted annual returns of 7.7% (versus 6.1%). Though the five-year timeframe is a problem, with an average annual return if 14.8% versus 4.4% for the Dow Jones Industrial Average, things got back on track again for the three-year and one-year timeframes. Over the past three years, the Small Dogs returned an average of 18.0%, compared to only 15% for the Dow Jones Index. In 2011, the Small Dogs again whipped the Dow and the ten regular dogs, averages gains of 19.2%.

Interested? Great. As it turns out - barring a miracle price change on Monday - 2013's Small Dogs still includes Pfizer and AT&T. But, you'll also want to be sure to add Hewlett-Packard Company (NYSE:HPQ), Intel Corporation (NASDAQ:INTC), and General Electric Company (NYSE:GE) to the list.

Admittedly, they're not easy names to own when Verizon, Johnson & Johnson (NYSE:JNJ), and Merck (NYSE:MRK) are just a small dip away from making the list.... especially when it comes to Intel and Hewlett-Packard, both of which have effectively whiffed on the advent of tablet PCs. But, numbers don't lie.