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 Can market 'dogs' outrun the rest? - Eureka Report Article 

March 26, 2008
Can market 'dogs' outrun the rest?
By Scott Francis
PORTFOLIO POINT: Maintaining a portfolio of the market's 10 highest-paying value stocks can offer outperformance; it can also be very volatile.


One of the more intriguing market theories is the Dogs of the Dow. It's a fascinating theory based on the premise that high income-paying stocks are unheralded gems. In a soft market or bear market atmosphere, such as the one we are enduring in mid-2008, the theory invariably gets a hearing.

In the US where the idea was first promoted it has become a widely discussed and applied theory. Now an Australian fund manager, Clime Capital, has made a timely entry into the market with a local variation based on Dogs of the ASX, called the High Yield Underdogs Fund. Is it for you?

What is the Dogs of the Dow strategy?

The basics of the Dogs of the Dow strategy is to invest in the highest income-paying stocks in an investment universe and then regularly, maybe at the end of every year, reweight the portfolio to the "new" highest income-earning stocks; usually to keep the 10 highest-paying stocks. This provides a very simple way of running an investment portfolio.

When it first appeared, the strategy was based on the 30 companies that make up the Dow Jones Industrial Average, also known as the Dow 30. It has a consistent following. Such is its popularity that there is even an Australian website named after the strategy www.dogsoftheasxcom. which recently produced the table reprinted below.

The Dogs of the ASX
Symbol Name
Yield
P/E
Price
52 WL
52 WH
SUN  Suncorp-Metway . 
9
8.91
12.51
11.08
21.95
SGB  St George Bank  
7.4
10.46
26.1
21.4
38.5
CBA  Commonwealth Bank
7.1
10.39
39.3
37.02
62.16
MQG  Macquarie Group  
6.9
7.37
49.5
43.33
83.59
TLS  Telstra Corporation . 
6.6
14.68
4.2
4.04
4.97
NAB  National Australia Bank  
6.5
10.33
29.11
25.85
44.84
WDC  Westfield Group 
6.2
18.48
17.78
16.54
22.28
AMP  AMP  
6.2
13.9
7.62
6.79
11.02
QBE  QBE Insurance Group  
6
9.58
23
19.5
35.49
WBC  Westpac
6
11.8
24.1
20.34
31.32
ANZ  ANZ Banking Group  
6
10.94
22.98
19.38
31.74
WES  Wesfarmers  
5.9
18.47
36.95
32.5
45.9
FGL  Foster's Group  
5
12.68
4.91
4.85
7.02
WOW  Woolworths  
3.1
21.51
28
25.97
35.05
BXB  Brambles  
2.6
19.75
9.63
9.11
14.93
WPL  Woodside Petroleum  
2.6
26.95
51.26
36.85
57.35
CSL  CSL  
2.1
29.97
37.88
26.667
39.18
BHP  BHP Billiton  
1.7
12.26
33.87
28.98
47.7
RIO  Rio Tinto  
1.3
19.14
116.29
76.57
149.99

The value premium

Ultimately, the theory hangs on the notion of "value" stocks - the idea that there might be a higher return for value companies, those companies that seem to be somehow "out of favour" with the market.

In 1987 Michelle Clayman published a study in the Journal of Finance (Volume 63, May-June). The article looked at the performance of a group of 29 "excellent" companies - using the criteria for an excellent company as identified in a New York Times best-seller written in 1982 by Tom Peters and Bob Waterman entitled In Search of Excellence. The criteria for excellence included average return on capital, average return on equity and compound asset and equity growth.

Using the same formula, Clayman identified the 29 worst stocks and called these the "unexcellent" companies. She then compared the investment return of the portfolios of the "excellent companies versus the unexcellent companies". From 1981 to 1985 the "unexcellent" companies outperformed the S&P 500 by 12%, while the "excellent" companies outperformed the S&P 500 by only 1%. The conclusion can be that the supposedly "unexcellent" companies are often so ignored by the market there is scope for strong returns when they do produce good financial results.

Another earlier study looking at value stocks was conducted by Paul Miller in 1964. Miller compared buying the 10 lowest and 10 highest price/earnings (P/E) stocks of the Dow 30 from July 1936 to June 1964. The P/E multiple is the price of the company divided by its earnings. A lower P/E is another definition of a value stock. He found the 10 lowest P/E stocks greatly outperformed the 10 highest; however, the lowest 10 P/E stocks also had a greater volatility of returns. This identified that returns for these stocks were more volatile, suggesting there was a greater "risk" in holding these shares.

In 1992, professors Gene Fama and Ken French published the paper the Cross-Section of Expected Stock Returns, in the Journal of Finance. This paper was the winner of the Smith-Breeden prize for the best paper in the magazine that year. The paper looked at returns for individual shares in the US sharemarket between 1963 and 1990. It found that:
  • Small companies had a higher expected return that large companies.
  • Value companies had a higher expected return than growth companies. The paper defined value companies as those with a low price to book ratio; that is; the share price of the company traded closer to the value of its assets than a growth company.

This group of evidence all suggested that value companies do have a higher expected return and therefore value is likely to be an area of the sharemarket that would make sense for people to invest in.

The Dogs of the Dow as a Value Strategy

Academic researchers have tended to follow the lead of Fama and French in using the "price to book" ratio as the preferred measure of value, as opposed to either dividend yield or the P/E. Price to book value is calculated as a ratio by dividing the equity value of the company into the market value of the company. They believe the idea of book value is more reliable year by year than either earnings or dividends. For example, a company may have negative earnings for a year that distorts its P/E ratio, or they may cut their dividend for a year, while the book value of a company remains more stable.

A more volatile strategy: not a free lunch

When you invest in value companies you are actually investing in riskier companies. Investment professionals tend to refer to value companies as being "out of favour", but remember they are out of favour for a reason. The website http://www.dogsoftheasx.com/ says that at the moment the five highest income-paying stocks among the top 20 are all banks and financial services stocks. Given the current credit crunch, these stocks do seem to hold additional risk; they are value stocks, and they are value stocks for a reason.

This is consistent with the research we looked at earlier, by Paul Miller, who found that shares with a low price earnings ratio had higher expected returns and were more volatile. The www.dogsofthedow.com website reported that their Dogs of the Dow return over the previous seven years underperformed the broader S&P 500 index in two years, twice once and outperformed four times. It had a higher average return, but it was also more volatile

In the Australian marketplace we have seen a period of underperformance by value companies over recent times, as market returns have been dominated by the big resource companies such as BHP Billiton, Rio Tinto and other resource companies.

Clime's High Yield Underdogs Fund

The first comment I would make on this fund is that it is interesting to see an active investment manager implement what is effectively a passive portfolio strategy. I describe it as a passive strategy because the investment approach is simply to build a portfolio of the highest income-paying stocks in the market, effectively using market signals for all the information used in portfolio selection.

The fund's investment strategy is to invest in the 10 highest income-paying companies in the top 100, in equal weights.

The process of identifying stocks for the portfolio is described in the product disclosure statement as a three step process:

  1. Identify the top 100 companies by size.
  2. Rank them by dividend yield.
  3. Buy equal weights of the top 10 by dividend yield.

This is a simple, passive process for building a portfolio. Of course, some more cynically inclined might question why you need a fund manager to do this for you.

Clime's product disclosure statement says that there are actually six occasions through the year when separate portfolios are set up and then rebalanced; the basics of the Dogs of the Dow strategy is a once-a-year rebalance.

The fact that every 12 months there is a recalculation of the 10 securities in Clime's Dogs of the ASX fund means there can be a relatively high level of trading. For each of the 10 equally weighted securities that are traded at the end of the year, that effectively means a 10% portfolio turnover. Trading four stocks means a turnover of 40%. That is before any other trading is done relating to the applications and redemptions processed by the managed fund during the year.

What's more, 10 securities is not a particularly well diversified portfolio. If any of the 10 equally weighted holdings were to fall in value sharply then that would negatively impact the overall value of the portfolio.

In practice there are six portfolios within the fund, that are rebalanced on their anniversary date. Although this may moderate some concerns about trading and diversification, you would still expect many of the six portfolios to look similar, and to have some trading in each portfolio every year.

A closer look at the prospectus shows that there are expense fees of up to 0.67% a year, and a performance fee of 10.25% when Clime satisfies a "certain performance level for the fund". That performance level is 0%. If we accept that the average return from the Australian sharemarkets is 7% above inflation, and the Reserve Bank is successful in keeping inflation at about 2.5%, then the expected return from a share portfolio going forward is 9.5%. The performance fee on this will be 0.97% (10.25% of a 9.5% market return). If there is a period of negative returns then the performance fee is not charged until the negative return is recovered.

This is a total fee of 1.64% (performance fee assuming a 9.5% pre-fee fund return and the full amount of the expense fee). This is expensive compared to other passive investments such as index funds, exchange traded funds and the other passive value funds where you would expect fees of less than 1%.

Other 'passive' value funds

Two other funds in the Australian market use a similar passive philosophy and a value approach.

A good example is the Vanguard Australian High Yield fund, which aims to produce a gross income 1% a year higher than the ASX 200 index (excluding property trusts). This could be said to target a value approach using yield as a marker of value, similar to the Dogs of the Dow strategy. The Vanguard fund only has performance data for three years to the end of February. It has underperformed the average market return (ASX 200) by 2.3% over this period, although it should be noted that this was a time of generally poor returns for a value strategy.

Conclusion

The Dogs of the Dow theory is engaging but it needs to be carefully thought through. In the case of the Clime High Yield Underdogs Fund, investors will have to weigh up whether the high fees for a passive strategy, relative lack of diversification and the fact that they could probably execute the simple and transparent investment strategy themselves, would be useful for them.

Scott Francis' articles in the Eureka Report 

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