High-dividend, high-quality stocks could provide relative security during what is shaping up to be another turbulent summer for the stock market. The Dogs of the Dow fit this description and frequently outperform when the stock market struggles. That was the case last year and again in May of this year. Risk-averse investors may want to consider these stocks for the intermediate term.

The Dogs Approach

The Dogs of the Dow are the ten Dow Jones Industrial Average stocks with the highest dividend yield.

The Dogs investment approach involves buying these stocks at the start of each year and selling them at the end of the year, starting over again with the new year.

The strategy has two advantages. First, these stocks provide an excellent dividend yield. Second, the stocks of these high-quality companies are often depressed for reasons that prove temporary, and there are usually one or two of the stocks that significantly outperform.

The Dogs strategy tends to work best when stock market gains are limited or when the market dips. When the stock market is rallying strongly, the Dogs approach often underperforms because growth stocks rise more sharply than these less volatile stocks.

Last year, while the S&P 500 was dead flat, the Dogs provided a return of 17%. This was covered in the January 9 Big Picture article, "The 17% Stock Return of 2011."

The Dogs have underperformed the S&P 500 so far this year, trailing when the market was rallying strongly January through April. For the year to date, the Dogs are up 2.7% while the S&P is up 4.8%. (The difference is reduced by the fact that the Dogs have an annual dividend yield of close to 4% while the S&P yields 2.1%).

In May, however, the S&P 500 is down 6.3%, while the Dogs are down 3.8%. The Dogs have provided a defensive stance as the market has dropped sharply. If the stock market struggles through the rest of the summer, the Dogs may well outperform. In fact, if the market trends sideways, the Dogs could provide a relatively strong return, similar to what happened in 2011.

The Dogs so Far this Year

The Dogs are defined at the beginning of each calendar year and we’ll continue to use that definition as of the first of this year.

For 2012 the Dogs are:

The current indicated year-ahead yield on these stocks in aggregate is about 3.94%. That is a pretty good yield compared to the 2.1% for the S&P 500 overall, and the even lower 1.73% yield on a government 10-year note.

That yield provides some downside protection should the market continue to struggle through the summer.

Relatively Low Risk 

These stocks are also generally stable. Their betas are listed below. Beta is a measure of a stock’s volatility relative to the market overall. A low beta indicates low volatility.

There are various measures of beta and some may differ from the values presented. The data above are from Yahoo Finance.

As can be seen, General Electric and DuPont can be volatile stocks, but most are very stable relative to the overall market.

Performance in Various Market Conditions

The Dogs are relatively stable stocks that could outperform a near flat market this summer, just as was the case in 2011. If the market rises sharply, these stocks will probably underperform the broad market but still provide good returns enhanced by the high dividend yield.

For the April through August period in 2010, the S&P 500 fell 11.0%. Last year over the same period the S&P fell 8.5%. This year, the S&P 500 is already down 6.3% in May.

It is hard to assess how the market will perform through August, but there is a very good chance that European concerns will continue to hang over that market. With that in mind, it would not be unreasonable to expect the S&P 500, while volatile, to end August near current levels. If that were to occur, it could well be that the Dogs outperform. At the least, the dividend yield of 3.7% provides a decent return.

One of the advantages of investing in the Dogs is that there are frequently sleepers that suddenly, and unexpectedly, come to life. They are called the Dogs for a reason – these are stocks that have been depressed in value, often because the businesses are beset by some temporary problems.

In 2011, the total return for the Dogs benefited significantly because McDonald's went on a run. It is possible that one of the current Dogs might go on a run this summer.

General Electric, for example, has upside potential as its financing unit results improve. Also, General Electric and Johnson & Johnson stock values are currently depressed by concerns about their European exposure. If those concerns subside, the earnings growth in both companies the past year will be rewarded with a higher multiple.

The Dogs are high-quality companies and the depressed stock values often snap back sharply as ever-changing conditions and market fashions move back in their favor. According to the dogsofthedow.com web site, the Dogs approach has returned 17% annually since 1973.

It is hard to foresee in any given year which of the Dogs will rally and boost that overall return, but that is one of the reasons the approach works – the out-of-fashion stock unexpectedly returns to fashion.

What It All Means

The market is just beginning what historically has been the most difficult seasonal period. Over the past 50 years, the May through October period has been close to flat. Almost all of the market gains have come from the November through April months.

The May selloff this year has created some long-term investment opportunities, as was discussed for tech stocks in last week’s Big Picture article. However, for an intermediate-term approach, a defensive posture is worthy of consideration.

The Dogs of the Dow stocks provide good yields and a low risk (relative to other stocks) approach that often leads to unexpected gains when one of the stocks recovers from depressed levels. Many risk-averse but relatively active investors might want to consider these stocks for the summer months ahead.

Dick Green

Founder and Chairman, Briefing.com