Own Dogs Of The S&P To Start 2023

Two of my wonderful followers read a blog post of mine on portfolio management and wrote me their thoughts on it, and their sharing encouraged me to pen the following article. I hope they – as well as my other readers, both current and new ones – will enjoy this too.

Preamble

January is the time of the year when articles like “Dow Dogs, Led by Chevron and Merck, Beat the Dow Industrials in 2022” appear.

Does that mean the Dogs of the Dow is the best approach to set up your portfolio in 2023? After all, its past results seemed great. The following chart and table from the aptly named website Dogs of the Dow show portfolios derived from variations of the Dogs of the Dow outperformed S&P 500, Dow Jones Industrial Index, Fidelity Magellan, and Vanguard Index 500 all the way from 2000 till 2018.

And this approach is so simple to apply! Just buy these 10 stocks at the start of the year and forget about them for the next 12 months, and you will be rich!

This article talks about this strategy, two variations of it, and my modification of the Dogs approach, which admittedly requires more work on your part (do not worry as I have already done of it a lot for you!) but is a far more sensible and data-driven approach, in my opinion.

By the end of this article, I will reveal the 5 stock picks derived from my version of the Dogs of the S&P 500. You can scroll all the way down to see these 5 stocks. Alternatively, you can read the article in its entirety to understand my process.

Introduction to Dogs of the Dow Approach to Creating a Portfolio

The Dogs of the Dow was introduced in the book Beating the Dow by Michael O’Higgins and John Downes. This is a simple approach that calls for an investor to buy the ten highest-yielding stocks in the Dow Jones industrial average at the start of every calendar year. An equal dollar amount is allocated to each of these ten stocks, and the stocks are held for twelve months. On the first trading day of the next calendar year, the process is repeated with the new highest yielders, and that may involve removing a couple of the previous ones. No thinking nor analysis is required when using this straightforward method.

Problems with the Classic Dogs of the Dow

The biggest challenge with the Dogs of the Dow strategy is that the ten stocks in the final portfolio are selected from a very limited universe of the thirty stocks that make up the Dow Jones Industrial Index. This stock-picking approach results in a concentrated portfolio. Any major setback in one particular stock, assuming all ten holdings are equal-weighted, may result in a 10% hit.

The following is the 2023 Dogs of the Dow. 70% of these performed poorly in 2022, including the venerable Intel (NASDAQ: INTC), which also happened to be the worst performer after experiencing a humbling 48.7% decline.

Personally, I will not advise a new investor who is starting out and building a portfolio to simply buy these ten dog stocks and hope for the best in the next 12 months. Any investment of hard-earned money should require due diligence. Going back again to the Intel example. It is riding on the wave of the CHIPS act and having invested in the building of two leading-edge chip factories in Arizona and another two in Ohio, it is arguably the standard bearer for a new era of “Made-in-America” chips, and in the words of CEO Pat Gelsinger, “leading the effort to restore U.S. semiconductor manufacturing leadership”. However, those plants will take at least another two years to be completed, and it may only be in 2025 that these investments will start to generate revenue. Investing in Intel has to be a long-term play that is beyond the scope of the Dogs of the Dog strategy.

Variation 1: SDOG ETF

This variation of the Dogs of the Dow is the ALPS Sector Dividend Dogs ETF (NYSEARCA: SDOG). The idea behind it addresses one main complaint about the classic Dogs of the Dow – having to select 10 highest-yielding stocks from a basket of just 30 stocks. Instead, this ETF is made up of stocks from the S&P 500. Moreover, 5 stocks from 10 of the 11 GICS sectors from the 500 stocks with the highest yields are selected by the end of November of each year to form the constituents of this ETF. Finally, the managers also rebalance this portfolio every quarter.

There is certainly diversification in this approach. The idea behind it – to increase the selection basket from 30 Dow Jones stocks to 500 stocks, and to increase the number of stocks in the portfolio from 10 to 50 – have merit.

There is just one problem: this ETF underperformed the S&P 500 and Dow Jones Industrial Index over an 8-year period (shown below), as well as for 5-year and 3-year periods. That is not exactly a vote of confidence for this strategy, especially considering the 0.4% expense ratio for this ETF. Why go through all the trouble of investing in SDOG when one can pay a much lower 0.09% expense ratio to invest in the better-performing SPY instead?

Variation 2: Dogs of S&P 500

In his article, author Keith Speights recently suggested that “The Dogs of the Dow Worked Last Year, But This Strategy Could Make You More Money in 2023“. His variation is just as simple as the classic Dogs of the Dow but it uses the Dogs of the S&P 500 instead by surfacing the 10 highest-yielding stocks in the S&P 500 rather than from the Dow Jones Industrial Index, holding these for a year, then rinses and repeat for 2024.

This method certainly addresses the critique against the Classic Dog strategy of having too few stocks to choose from. The author also claimed that his approach resulted in a group of stocks with “a reasonable level of diversification”, a claim which I disagree. His list has 30% of the stocks (PXD, CTRA, and DVN) in the Oil and Gas Exploration sub-industry and another 30% in REITs (SPG, BXP, and VNO), and if having 60% of the portfolio in just two sectors is not considered sector concentration, I do not know what is. Perhaps these are all great companies that will outperform in 2023 as Keith suggested but I cannot in good faith tell a new investor to buy these 10 dog stocks and hope for the best by the end of 2023.

In addition, as a value investor, I will be extremely careful when investing in sectors that are currently overvalued, such as Energy (see Morningstar fair value barometer chart below).

Caveat: As Mr. Valuation Chuck Carnevale always says, “this is a market of stocks, not a stock market”. Having said that the Energy sector is overvalued does not mean there cannot be pockets of undervaluation or companies being mispriced and deserving of attention. Perhaps PXD, CTRA, and DVN are three undervalued opportunities in an overvalued sector. After all, they are all trading in the single-digit P/E, and that is lower than their respective past 5-year average P/E. However, what would happen to those nice, low P/E if earnings were to fall in 2023? FactSet analysts are forecasting a 21% decline in adjusted operating earnings for PXD, a 26% fall for CTRA, and a mere 0.23% “growth” for DVN followed by consecutive declines of -10% and -12% in 2024 and 2025, respectively. A fall in earnings will lead to a spike in P/E, and suddenly these low P/E stocks will appear to be less cheap. My point is simply don’t buy these 10 stocks without doing further research.

The Dogs of the S&P is an intriguing idea. And it is simple to apply too. I do believe in keeping things simple, but to think that successful investing can be this simple is foolish. Howard Marks had this to say about “investing is easy”,

What Charlie and Professor Galbraith meant is this: Everyone wants to make money, and especially to find the sure thing or “silver bullet” that will allow them to do it without commensurate risk. Thus they work hard (actually, study is intense), searching for bargain securities and approaches that will give them an edge. They buy up the bargains and apply the approaches. The result is that the efforts of these market participants tend to drive out opportunities for easy money. Securities become more fairly priced, and free lunches become harder to find. It makes no sense to think it would be otherwise.

And what about the next seven words: “Anyone who finds it easy is stupid”? It follows from the above that given how hard investors work to find special opportunities, and that their buying eliminates such prospects, people who think it can be easy overlook substantial nuance and complexity.”

To be clear, I do believe there is merit and utility to the Dogs of the Dow approach, and even more so for the Dogs of the S&P 500 strategy. I simply think that a list of tickers generated by any approach can only be the start – not the end – of the investment journey. If an investor wants his portfolio to outperform, he has to do more work. In the next segment, I will share my variation, and what that looks like in the end.

My Variation: Dogs of S&P 500 + Analysts’ Forecast + Deeper Dives

There are thousands of stocks – too many to do deep dives on – so having a screening methodology like the Dogs of the Dow (or in this case the Dogs of the S&P 500) does help to narrow the field down to a more manageable number for further research.

My variation on Dogs of S&P 500:

1. Narrow the stocks in the S&P 500 down to the top 50 highest-yielding ones.

2. Next, I will further sort the companies by their

(i) Credit Rating

(ii) Long-term Debt/Capital Ratio

(iii) Dividend Yield

(iv) GICS Industry

As these are dividend-paying stocks, a minor calamitous event will be a dividend cut, and to reduce the chances of that I foreground the financial safety of these companies by sorting them by their credit rating and their long-term debt/capital ratio.

3. Analysts’ earnings per share estimates are included in the decision-making matrix. If a company is expected to face a drastic fall in earnings in 2023, unless there are very strong reasons for investing in it, I would avoid investing in that company. A downloadable link to the full list is available here.

4. I avoid stocks in the overvalued “Oil and Gas Exploration and Production” sub-industry as most of the analysts (except those from SPGI) are forecasting either a double-digit decline in earnings or almost zero growth in earnings in 2023.

5. I avoid stocks where the consensus from at least two of the three rating agencies is consistently negative, regardless of the high dividend yield or high average earnings growth estimates of the stock. Three examples of companies that I avoid are Lumen Technologies (NYSE: LUMN), AT&T (NYSE: T), and Seagate (NASDAQ: STX). The average adjusted operating growth projection for STX is pretty amazing at 31.58%. However, that figure is positively skewed by the 176.5% growth estimate from analysts from Refinitiv; FactSet analysts think the earnings will fall by 78.44% while SPGI analysts believe earnings will decline by 3.31%. The huge divergence in analysts’ opinions tells me it is not easy to forecast the earnings of this company, so I will avoid trusting their numbers.

6. I avoid stocks with projected earnings growth lower than 10%. This is an arbitrary figure that I use; you can choose a higher or lower figure. I chose 10% because it meets my threshold of a “double-digit” return in earnings, and after factoring in returns from the dividend yield, the total potential return is substantial (for me anyway) for at least a 12-month holding period. An example of such a company that I avoid is Edison International (NYSE: EIX).

7. Next, I move on to the REITs list. Before delving in, let me share some views from research done by NAREIT,

While property fundamentals generally remained solid at the end of 2022, there has been some evidence of softening going into 2023. The industrial, retail, and apartment property types maintained elevated occupancy rates that were higher than their respective pre-pandemic levels. Office occupancy continued its downward trajectory, dropping nearly 3% from its 2019 average. Four-quarter rent growth rates remained healthy for the industrial, retail, and apartment sectors; office continued work toward maintaining positive rent gains.

Higher interest rates and debt costs are throttling commercial real estate transaction volume. The combination of high rates and weak valuations resulted in a dearth of REIT capital raising in the third quarter of 2022; it is at its lowest level since 2009.

Based on the research by the National Association of Real Estate Investment Trusts, investors may want to temporarily avoid Office REITs and Commercial REITs. Office REITs build, manage, and maintain office buildings, and they lease the offices to companies that need space to house their employees. Commercial REITs specialize in commercial properties including office buildings, hotels, manufacturing buildings, convenience stores, etc.

Applying the above criteria and insights from NAREIT, I am left with only VICI from the REITs category.

At the end of these 7 steps, I am left with the following 9 stocks.

8. As these are high dividend-yielding stocks, a dividend cut will not be a positive catalyst. Using Seeking Alpha’s Dividend Rating tool, I screened for dividend safety, dividend growth, and payout ratio to sieve out stocks with the highest chances of cutting their dividends, and cull these.

Finally, this leaves us with 6 stocks to do deeper dives on, or 5 if we exclude NRG due to its more speculative BB+ credit rating.

By the end of this long-drawn series of steps, I know these 5 stocks (excluding NRG) have met the following criteria:

1. They offer some of the highest yields (averaging 4.77%)

2. They are all investment grades ranging from A+ to BBB-

3. Analysts from three different companies have forecast positive adjusted operating earnings growth in 2023 (averaging 26.33%)

4. They have Seeking Alpha’s dividend safety grades ranging from A- to B-

5. Dividend payout ratio is under 50% (with the exception of the 2 MLPs and the REIT as it is normal for those figures to exceed 100%)

6. They have Seeking Alpha’s EPS revision grades ranging from A+ to C

Of course, that is NOT the end of the story. If any of these 5 stocks catches your fancy, it is up to you, my dear reader, to dig in deeper. The link to the full list is available here.

Conclusion

The Dogs of the Dow approach is an attractive way to select stocks as it is easy to understand, easy to apply, and there is plenty of data to support its efficacy.

I do believe that an approach like the Dogs of the S&P 500 is an improvement upon the classic Dogs of the Dow by expanding the universe of stocks available for our consideration, and these approaches are useful screens to generate an initial list of candidate stocks.

However, I do not think that investors should go off to buy stocks generated from screens. Seasoned investors would definitely not do such a thing but newer investors may be influenced by the many articles exhorting the Dogs of the Dow strategy that emphasized the Dog’s 2022 outperformance against the Dow Jones Industrial Index without discussing the potential downfalls. And who does not like a simple and “sure-win” strategy? The problem is there is no such thing, and to think that investing is simple would be too naive.

Peter Lynch shared once how he was amazed at the enormous amount of time people spent researching for the best washing machine but afforded hardly any time researching a stock before committing thousands of dollars to buy shares of that stock. Information is readily available in the world we live in today, and it will be a shame not to utilize the tools available to us in order to make the best possible choices.

Finally, compare the three Dog lists in this article: the 2023 Classic Dogs of the Dow 2023, the 2023 Dogs of the S&P 500, and my list of 2023 Dogs of the S&P 500. Which list gives you the most confidence?

What do you think of the Dogs of the Dow/S&P 500 approach? Are you an adherent? Do share your views with me in the comments section below.