A Better Idea Than the Dogs of the Dow

Can an old dog's trick really put more value in your portfolio?

The "Dogs of the Dow" is an old-timer's investment strategy that calls for buying the 10 highest-yielding stocks in the Dow Jones Industrial Average at the end of every year. It was a pretty good strategy back in the day, but it hasn't done so well in recent times. In fact, going into last year, it had lagged the Dow itself in 10 of the last 15 years.

But in 2011, it put up quite a respectable showing. Its returns beat those of the overall Dow by almost 7% -- 12.2% gain for the Dogs versus just 5.5% for the index. Truth be told, though, it's an outdated and overly simplistic strategy that's unlikely to work much better than a dartboard over the long haul.

But the basic concept behind it is a surprisingly useful one.

The key to the strategy: automatic value
The idea behind the Dogs was that it would improve the odds that you were buying value -- higher-yielding dividend stocks were once thought to be more likely to be undervalued stocks. By using a system to pick and buy 10 of them every year, and a discipline that forced you to sell them all a year later, one would eliminate one's own biases from the selection process, and end up holding stocks that -- in theory -- had a better chance to appreciate than their lower-yielding peers.

It mostly hasn't worked well in recent years for a bunch of reasons, one of which is that a "high" yield is a relative thing -- one that varies by sector. Steady-as-she-goes telecomAT&T (NYS: T) , which is essentially a utility stock that counts on regular streams of monthly payments from its customers, should pay a higher yield than high-margin consumer staples firmKraft Foods (NYS: KFT) , which is (at least in theory) more likely to post revenue growth -- and thus see its stock price rise -- in any given year. The Dogs' assumption that a high yield must mean value pricing isn't really valid anymore, to the extent that it ever was.

Instead, an investor following the strategy typically ends up buying stocks in sectors like telecoms and pharmaceuticals, where high yields tend to be the norm year after year. That makes it a little too much of a sector-specific strategy. But the essential idea behind it -- a rules-driven investing system that uses a screen for simple, objective criteria -- has a lot of merit, and there's a good twist on it that may be worth your while.

Enter the Magic Formula
The "Magic Formula" is a system introduced a few years back in former hedge fund manager Joel Greenblatt's The Little Book That Beats the Market. Like the Dogs, it's a simple mechanical system that seeks to put more value into your portfolio -- but it's a little more sophisticated, and a lot more successful.

The gist of the Magic Formula is this: After applying a couple of screens to eliminate outliers, one screens for companies that are both cheap and profitable, the cheaper and more profitable the better. Greenblatt has some fairly precise (and tested) metrics for measuring both:

  • To find cheap companies, Greenblatt screens for high earnings yield -- essentially, the company's pre-tax earnings divided by its enterprise value. It's similar to seeking low price-to-earnings ratios, but a bit more refined. The Magic Formula looks for earnings yields above 10%.

  • To find profitable companies, the Magic Formula looks for a return on assets greater than 25%.

Approximating these metrics with a conventional screener is tricky, as most don't have anything close to Greenblatt's earnings yield calculation. But there are a few different ways to do it. One of my favorites is to cheat and use the free screener on Greenblatt's own Magic Formula site, which yielded these stocks (among others) when I tried it recently:

  • Lear (NYS: LEA) is a "Tier 1" -- industry slang for "big-time" -- auto supplier headquartered in Michigan. Like two of its biggest clients (General Motors and Chrysler), Lear went into bankruptcy in 2009, and like the Detroit automakers, newly restructured Lear is enjoying a renaissance at the moment, even as the stock market hasn't quite caught on. Lear's key product lines are auto seats and electrical parts, its parts are found in cutting-edge products like the Chevy Volt as well as hot sellers like the Ford Explorer, and it's well-positioned to benefit as the U.S. automakers (and the U.S. economy) continue to recover. In recognition of its strong prospects, Motley Fool CAPS players have given Lear a top five-star rating.

  • Audio technology whiz Dolby Labs (NYS: DLB) is a very well-run company that has been beaten down after a tumultuous 2011 in which investors learned that the company's days of licensing its technology to Microsoft were likely numbered. But there are lots of reasons to believe that the company will continue to see strong results in 2012 and beyond -- enough to garner Dolby the coveted five-star rating in Motley Fool CAPS.

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At the time thisarticle was published Fool contributorJohn Rosevearowns shares of Ford and General Motors, but he holds no other position in any company mentioned. The Motley Fool owns shares of Microsoft and Ford.Motley Fool newsletter serviceshave recommended buying shares of Microsoft, Ford, Dolby Labs, and General Motors, as well as creating a bull call spread position in Microsoft and a synthetic long position in Ford. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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