Jack Hough: New Dogs of the Dow

DIVIDENDS GAVE BIRTH to the stock market, not the other way around. Before 1600 there were plenty of share-issuing sea merchants. (Something about floating one's wealth over open seas inspires thoughts of spreading start-up costs and risk, even if that means splitting profits.) But they folded after each voyage so that owners could split up the bounty. The world's first stock exchange was established in 1602 to trade the world's first true stock, Dutch East India, largely because a profit-sharing innovation allowed Dutch East to operate continuously for centuries. In an era when accounting standards were few, it was better than promises or trust. It was cash in the pocket — a dividend.

From the start, big dividends have been closely linked with share-price gains. Through 1635, Dutch East paid dividends only occasionally, but from then on it paid one every year. These weren't the 1% payouts today's investors have come to expect. Payments topped 60% in the best years. The bigger the dividends grew, the more attractive the shares became. By 1650, Dutch East shares had multiplied sixfold in value.

If big dividends generally lead to higher share prices, finding stock bargains should be easy. Simply look for companies with the lowest share prices relative to their dividend payments. In other words, look for high dividend yields.

One of the most popular investment strategies of the 1990s, which still has plenty of fans today, does just that. It's called the Dogs of the Dow strategy. Start with the 30 companies that make up the Dow Jones Industrial Average. They're all household names like Caterpillar (CAT), Coca-Cola (KO) and Microsoft (MSFT). Choose the 10 of these companies that have the highest dividend yields. Buy them. Hold a year. Repeat.

Over the 50 years ended 1995, the Dogs beat the Dow by three percentage points a year. In the 1990s Wall Street launched scores of packaged investment products based on the strategy. But investors who bought them might be growing impatient. Despite an impressive showing in 2006, the strategy over the 11 years since 1995 has produced annual gains of 6.7% and dividends of 3.4%, no match for the Dow's 9.4% yearly gains and 2.1% dividends. The once unstoppable Dogs have been making puddles in investors' portfolios.

Have dividends lost their appeal? Certainly not. Quarterly cash payments are still an excellent sign of financial strength and shareholder-friendly management, and they're particularly welcome in a market slowdown, since yields rise as share prices fall, luring buyers. But dividends now share their predictive power with another financial innovation: share repurchases.

Share repurchases, like dividends, represent profits returned to shareholders. They serve to reduce a company's share count, thereby increasing its earnings per share and the value of remaining shares. Unlike dividends, repurchases don't result in taxes for investors. A quarter century ago just 10% of the profits companies returned to shareholders went for repurchases, and the rest for dividends. Now it's an even split.

High-yield stocks are still attractive, but investors might want to change the way they define yield. In a paper published in the Journal of Finance in 2004, four finance professors studied the predictive power of a new measure they called net payout yield. Simply combine the money a company has spent on dividends and repurchases over the past year, while subtracting the amount it has collected from issuing new shares (the opposite of a repurchase). Divide this figure by the market value of outstanding shares. So a $100 million company that spends $3 million on dividends and $5 million on share repurchases (after subtracting for issuances) has a net payout yield of 8%.

The professors studied returns for thousands of companies for 32 years ended 2003. The broad stock market during that time returned a handsome 13% a year. Stocks with high dividend yields did even better, returning a couple of extra percentage points per year. Those with high net payout yields, though, beat the broad market by a whopping five percentage points a year. In dollar terms, the broad market would have turned a $10,000 investment during their study period into a half million dollars. Stocks with high net payout yields would have turned it into more than $2 million.

Next the four professors turned their attention to the Dogs of the Dow. They looked at performance figures between mid-1983, when repurchase activity started to pick up, and the end of 2005. The Dogs returned 16.2% a year during that period, beating the Dow Jones Industrial Average by nearly three percentage points a year. But an updated set of Dogs based on net payout yield rather than dividend yield returned an astounding 19.1% a year.

You can use this information to create a New Dogs strategy. Simply search the index of your choice (Dow, S&P 500) for high net payout yields. The easiest was to do that is with stock-screening software. Unfortunately, the measure is fairly new, so screeners generally don't include it. I've pestered SmartMoney.com into adding it to their screener (which is available to Select subscribers), and they've been kind enough to create a one-click New Dogs screen that visitors can run for free on my book page. To go straight to a list of Dow stocks ranked by net payout yield, click here.

Reprinted by permission of the publisher, John Wiley & Sons, Inc., from "Your Next Great Stock: How to Screen the Market for Tomorrow's Top Performers." Copyright (c) 2008 by Jack Hough. All rights reserved.