Category Index: Strategy

     Strategy - Dogs of the Dow

This article discusses an investment strategy commonly called "Dogs of the Dow."

The Dow Jones Industrials represent an elite club of thirty titans of industry such as Exxon, IBM, ATT, DuPont, Philip Morris, and Proctor & Gamble. From time to time, some companies are dropped from the Dow as new ones are added. By investing in stocks from this exclusive list, you know you're buying quality companies. The idea behind the "Dogs of the Dow" strategy is to buy those DJI companies with the lowest P/E ratios and highest dividend yields. By doing so, you're selecting those Dow stocks that are cheapest relative to their peers.

So here is the Dogs of the Dow strategy in a nutshell: at the beginning of the year, buy equal dollar amounts of the 10 DJI stocks with the highest dividend yields. Hold these companies exactly
one year. At the end of the year, adjust the portfolio to have just the current "dogs of the Dow." What you're doing is buying good companies when they're temporarily out of favor and their stock prices are low. Hopefully, you'll be selling them after they've rebounded. Then you simply buy the next batch of Dow laggards.

Why does this work? The basic theory is that the 30 Dow Jones Industrial stocks represent well known, mature companies that have strong balance sheets with sufficient financial strength to ride out rough times. Some people use 5 companies, some use 10, some just one. You might call this a contrarian's favorite strategy.

A 12/13/93 Barron's article discussed "The Dogs of the Dow." Barron's claimed that using this strategy with the top 10 highest yielding Dow stocks returned 28% for 1993, which was 2x the overall DJIA, 2x the NASDAQ, 4x the S&P500 and better than 97% of all general US equity funds (including Magellan). In the last 20 years, this strategy has lost money in only 3 years, the worst a 7.6% drop in 1990. In the last 10 years, it has returned 18.26%.

Merrill Lynch offers a "Select 10 Portfolio" unit trust, which invests in the top 10 yielding Dow stocks. Smith Barney/Shearson, Prudential Securities, Paine Webber, and Dean Witter also offer it. It has a 1% load and a 1.75% annual management fee, and they are automatically liquidated each year (cash or rollover into next year, but capital gains are realized/taxed). Minimum investment is $1,000.

A listing of the current "DOGS of the DOW" is updated every day on the "Daily Dow" page that is part of the Motley Fool web site:

http://www.fool.com/DDow/DDow.htm

 Strategy - Hedging

Hedging is a way of reducing some of the risk involved in holding an investment. There are many different risks against which one can hedge and many different methods of hedging. When someone mentions hedging, think of insurance. A hedge is just a way of insuring an investment against risk.

Consider a simple (perhaps the simplest) case. Much of the risk in holding any particular stock is market risk; i.e. if the market falls sharply, chances are that any particular stock will fall too. So if you own a stock with good prospects but you think the stock market in general is overpriced, you may be well advised to hedge your position.

There are many ways of hedging against market risk. The simplest, but most expensive method, is to buy a put option for the stock you own. (It's most expensive because you're buying insurance not only against market risk but against the risk of the specific security as well.) You can buy a put option on the market (like an OEX put) which will
cover general market declines. You can hedge by selling financial futures (e.g. the S&P 500 futures).

In my opinion, the best (and cheapest) hedge is to sell short the stock of a competitor to the company whose stock you hold. For example, if you like Microsoft and think they will eat Borland's lunch, buy MSFT and short BORL. No matter which way the market as a whole goes, the offsetting positions hedge away the market risk. You make money as long as you're right about the relative competitive positions of the two companies, and it doesn't matter whether the market zooms or crashes.

If you're trying to hedge an entire portfolio, futures are probably the cheapest way to do so. But keep in mind the following points.

 •The efficiency of the hedge is strongly dependent on your estimate of the correlation between your high-beta portfolio and the broad market index.
      •If the market goes up, you may need to advance more margin to cover your short position, and will not be able to use your stocks to cover the margin calls.
      •If the market moves up, you will not participate in the rally, because by intention, you've set up your futures position as a complete hedge.
      You might also consider the purchase out-of-the-money put LEAPS on the OEX, as way of setting up a hedge against major market drops.

Another technique would be to sell covered calls on your stocks (assuming they have options). You won't be completely covered against major market drops, but will have some protection, and some possibility of participating in a rally (assuming you can "roll up" for a credit).

When to Buy/Sell Stocks

This article presents one person's opinions on when to buy or sell stocks. Your mileage will certainly vary.

Stock XYZ used to trade at 40 and it has dropped to 25. Is it a good buy?
A: Maybe. Buying stocks just because they look "cheap" isn't a good idea. All too often they look cheaper later on. (Oak Industries, in Cable TV equipment, used to sell in the 40s. Lately, it's recovered from 1 to 3. IBM looked "cheap" when it went from 137 or so down to 90. You know the rest.) Wait for XYZ to demonstrate that it has quit going down and is showing some sign of strength, perhaps purchasing in the 28 range. If you are expecting a return to 40, you can give up a few points initially. Note that this situation is the same as trying to sell at the top, except the situation is inverted. See the comments on "base building" in the Technical Analysis section of the FAQ.

I'd like to sell a stock since I have a good profit, but I don't
want to pay the taxes. What should I do?
A: Sell the stock and pay the taxes. Seriously, if you have profits, the government wants their (unfair) share. Their hand (via the IRS) is in your pocket. If you don't make any money, then you won't owe the government anything.

I have a profit in a stock and I want to sell at the exact top. How do I do that?
A: If anybody knows how, they haven't told me. Some technical indicators such as RSI can be helpful in locating approximate local maxima. Fundamental valuations such as P/E or P/D can suggest overvalued ranges.

What are some guidelines for selling when you have a profit?
A: Since you can't pick the exact top, you either sell too soon or too late. If you sell too soon, you may miss out on a substantial up move. If you sell too late, then you will preserve most of the last up move (unless you get caught in some sort of '87 type crash). One mechanical rule advocated by Jerry Klein (LA area) is this: If you have at least a 20 percent profit, use a (mental) stop to preserve 80 percent of your profit. The technical analysis approach is to determine a prior support level and set a stop slightly below there. Marty Zweig's book has an excellent discussion of trailing stops, both in setting them and how to use them.

It seems like stocks often drop excessively on just a little bit of bad news. What gives?
A: One explanation is the "cockroach theory". If you see one cockroach, there are probably a lot more around. If one piece of bad news gets out, the fear is that there are others not yet public. Similarly, if one stock in a group gets into trouble, there is a suspicion that the others might not be far behind.

I saw good news in the paper today. Should I buy the stock?
A: Not necessarily. Everyone saw the news in the paper, and the stock price has already reflected that news.

I don't want to be a short term trader. Can one of these computer programs help me for the long term?
A: Possibly. If you have decided to buy and the stock is still declining, a computer could help determine when a local bottom has been reached. This sort of technical analysis is not infallible, but the computations are somewhat awkward to do by hand calculator. These programs aren't free, downloading the data isn't free, and you will have to do some study to understand what the program is telling you. If you are more or less ready to sell, the program may be able to locate a local top. Ask your broker if he is using any kind of computer analysis for buy/sell decisions. If you already own a PC, then an analysis program might be cost effective.

How does market timing apply to stocks? (I understand about switching mutual funds using market timing signals).
A: Assuming that you think the market is "too high", you might a) tighten up your stops to preserve profits, b) sell off some positions to capture profits and reduce exposure, c) sell covered calls to provide some downside protection, d) purchase puts as "insurance", e) look for possible shorting situations, and/or f) delay any new purchases. If you think the market is "too low", then you might a) commit reserve money for new purchases and/or b) take profits from prior shorting.

Explain market action, group action, and individual stock action.
A: Every day, some stocks go up, some go down, and some are unchanged. Market action applies to the general direction of the market. Are most stocks going up or down? Are broad averages (S&P 500, etc.) going up or down? Group action refers to a specific industry group. Biotechs may be "hot", technology may be "hot", out of favor groups may be dropping. Finally, not all companies within a rising group will be doing equally well -- some individual stocks will have risen, some won't, some may even be sliding lower.

How do I use this information (assuming I've got it)?
A: A strategy is to locate a rising group in a rising market. Look for good companies in the group which haven't risen yet and purchase one or more of them. The assumption is that the "best" companies have already been bid up to full value and that some of the remaining will be bid up. Avoid the poorest companies in the group since they may not move at all.

Should I look at a chart before I purchase a stock?
A: Definitely. In fact, raise your right hand and repeat after me: "I will never purchase a stock without looking at a chart". Also, "I will never purchase a stock in a Stage 4 decline." (See technical analysis articles in this FAQ for details.) If you have a full service broker, he should send you a chart, Value Line report, and S&P report. If you can't get these, you aren't getting full service. Value Line and S&P are probably available in your local library.

Do I need to keep looking at charts while I am holding my positions?
A: Probably. You don't necessarily need to look a charts on a daily basis, but it is difficult to set trailing stops [ref 1] without looking at a chart. You can also get information about where the price is relative to the moving averages.

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