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Andrew Hallam is the index investor for Strategy Lab. Globe Unlimited subscribers can view his model portfolio here and read more in the series online here.
Back in 1991, Miami-based money manager Michael O'Higgins said it was easy to beat the market. He had been using a simple strategy to thump the index since 1978. Twenty-five years ago, he described it in his book, Beating the Dow.
It wasn't like other stock-picking books. Benjamin Graham's The Intelligent Investor and Peter Lynch's One Up on Wall Street were two favourites at the time. But the methods described by both authors required some effort and skill.
"In order to follow Benjamin Graham's or Peter Lynch's strategy," Mr. O'Higgins said, "you almost had to be Graham or Lynch. Anyone with 10 minutes to spend, basic arithmetic skills and the financial page of any newspaper could use my strategy." In other words, it was almost as easy as buying an index fund.
Back-tested results showed stellar returns. Beating the Dow described two strategies. Each of them starts by finding the 10 highest-yielding stocks in the Dow Jones industrial average. The first strategy is called Dogs of the Dow 10. Investors buy each of the Dow's 10 highest-yielding stocks in equal proportions. The second strategy was called Dogs of the Dow 5. Investors buy the five lowest-priced stocks among the top 10 yielders.
These are blue-chip companies that have often fallen on tough times. Dow companies have huge infrastructures, long histories, extensive customer bases and big revenue streams. "If the problem is poor management, new management comes in, sweeps away past policies, makes strategic changes that adjust to new realities, kicks the horse's flank to get it moving and starts making money again," Mr. O'Higgins said.
At the end of one year, investors reassess their portfolio. The stocks that no longer meet the original criteria are sold. They are replaced by those that do.
In his book, Mr. O'Higgins showed that both strategies had beaten the market from 1973 until 1990. If we extend their results from 1973 until March 3, 2016, they still look impressive.
The Dogs of the Dow 10 averaged a compound annual return of 13.07 per cent. The Dogs of the Dow 5 averaged 14.98 per cent a year. The S&P 500, by contrast, averaged 10.09 per cent, with the Dow Jones industrials averaging 10.35 per cent. But how have they performed since Mr. O'Higgins' book was published in 1991?
Over all, both have handily beaten the market. The Dow 5 strategy is the winner. It has now beaten the S&P 500 over the past one, three-, five-, 10-, 15-, 20- and 25-year periods. From 1991 until 2016, it gained an average annual compound return of 12.76 per cent. That would have turned $10,000 into $201,315. Investors in Vanguard's S&P 500 Index (VFINX) would have averaged a compound annual return of 9.7 per cent a year. The same $10,000 would have grown to $101,265.
But I'll guess that few investors, if any, actually earned those returns. When the Dogs of the Dow don't run, many investors likely bury them in the backyard.
In the five years after his book's publication (1991-95), the S&P 500 index gained 16.4 per cent a year. Mr. O'Higgins' Dogs of the Dow 5 gained 30.2 per cent a year. Book sales soared as if they were a new millennium tech stock. To many, Mr. O'Higgins became a messiah. Recalling those days, he said, "The extraordinary returns that the Dogs showed in the years immediately following Beating the Dow's publication were thrilling and led to many congratulatory letters, requests for interviews and lucrative speaking engagements."
But the canine crew was tested. The strategy hasn't beaten the market during every five-year period since 1991. The index thumped it between 1996 and 2000, gaining 18.3 per cent a year versus 12.4 per cent annually for Mr. O'Higgins' method. The U.S. market also eked out a win between 2006 and 2010. The S&P 500 gained 2.2 per cent a year. Mr. O'Higgins' stocks averaged 1.3 per cent.
David Stanley might be Canada's biggest proponent of the method. He wrote a 20-year-long column about it for Canadian MoneySaver, describing how to use the strategy with Canadian stocks. "At one point, I was very tempted to chuck it," he said. But now he's glad he didn't.
This year's Dogs of the Dow 5 include Pfizer (PFE), Cisco Systems (CSCO), Verizon Communications (VZ), Merck (MRK) and Wal-Mart (WMT). As of March 24, their dividend yields were 3.95 per cent, 3.68 per cent, 4.25 per cent, 3.47 per cent and 2.95 per cent, respectively.
If you want to beat the market, look in the mirror. If your reflection doesn't look like Warren Buffett, Peter Lynch or the late Benjamin Graham, perhaps you should harness the Dogs of the Dow.