Stock picking is an art and science, which the world’s famous investors such as Ben Graham and Warren Buffet have mastered over decades. Some of the most famous philosophies such as value investing, growth investing, dogs of the dow strategy, etc, have become the bible for portfolio managers and investors and have been included as important theories in advanced finance text in universities.
These are interesting to learn and hear about, but the million dollar question is “How many of these theories benefit ordinary investors such as you and me?” There is hardly a clear cut answer to this.
Stock Picking Strategies suited for Retail investors
Some of the strategies which can be easily implemented by retail investors include the ‘Dogs of the Dow Strategy’ and ‘Passive Investing Strategy’ in my view. This is keeping in mind the fact that downside risk is lower and returns are reasonably equal to or greater than index or benchmark returns (say Nifty or Sensex returns in India).
1. Passive investing : Passive Investing through index funds or exchange traded funds is a way to safely invest in indices and earn index-linked returns. This does not require stock picking capabilities or stock selection tools
2. Dogs of the Dow Strategy : Investors who are keen on picking their own stocks and willing to absorb the risk associated with direct equity investment can use the ‘Dogs of the Dow Strategy’. Let’s call it DOD strategy for the sake of simplicity.
The DOD stock picking strategy involves picking 10 stocks with the highest dividend yield, from the stocks comprising an index. If Dow index has 30 stock the investor shortlists the top 10 dividend yielding stocks and invests his money equally in these stocks and holds them for a year. After a year a new top 10 list is used and the portfolio is realigned by adding new stocks (in the new top 10 list) and by selling stocks (that are out of the top 10 list).
For an easier understanding let us see how it works step by step.
The Dogs of the Dow Strategy – How it works?
Let me explain the ‘Dogs of the Dow Strategy’ and how it should be implemented in a step-by-step fashion to avoid ambiguity: -
Step 1: Identify and choose the top 10 stocks in an Index (say Sensex, Nifty, etc. – this was originally used for Dow) based on dividend yield. Dividend yield in simple layman’s term is the yield you get on dividend versus the price you paid for the stock. Dividend Yield = Dividend/Stock’s Acquisition price.
Assuming you bought ITC for Rs.150 and the company declared a dividend. The company announces that they have paid a dividend of 150% on the face value of Re.1 per share in the current year. This means you earn a dividend of Rs.1 per share, while your acquisition price is Rs.150.
So, dividend yield = 1.5/150, which is just 1%.
This is just an illustration. In the current market ITC is also considered as a good dividend yield stock and preferred by conservative investors.
Step 2: Allocate your investments equally among these 10 stocks and hold the stocks for one year. This means you do nothing except for being patient for a year.
Step 3: After 1 year (say in 2012) repeat Step 1. Now the new top 10 stocks for 2012 will be different.
Step 4: Now you need to allocate your investments equally to the new 10 stocks in top 10 2012. You need to add or remove some stocks from your portfolio to align it with the new top 10 stocks chosen for 2012.
Step 4 involves the following: -
• Adding new stocks that have entered your new top 10 list.
• Removing stocks in your portfolio that are not part of the new top 10 list.
• Some stocks in the portfolio that are part of the new top 10 list can be retained or you can book profits partially.
Premise of the Strategy
The premise of the stock picking strategy is based the fact and research that revealed that the Dow laggards (out of flavor stocks) are fundamentally good companies if they remain in the Dow index for a longer period of time. When these out of flavor stocks under perform one can enter or invest in these. When markets turnaround and the company’s business cycle improves, the stock gets revalued and prices move up. This way you gain from price appreciation. Similarly you would also benefit from higher earnings or dividends that these companies declare.
Since the top 10 list has the best dividend yielding companies, during bear markets, higher earnings and dividends can still make these investments worth holding assuming the company’s balance sheet and fundamentals are strong. The other most important point to note is the fact that companies that are chosen for the index (Dow, Senses or Nifty) are fundamentally strong companies that are handpicked by a committee of market experts after a lot of screening and scrutiny. This ensures that you are investing in to the most reputed companies with a solid track record.
Practical Evidence – Does it really work?
Is stock picking that simple? Is the strategy of picking 10 stocks really that easy? Simple, but does it really work? This is the million dollar question. Like any other strategy there can be pros and cons to the DOD strategy, but historical data shows that it works over a longer term. If you want to see good results or fruits of this strategy you need to be patient and have faith for the long term.
Example: From 1957 to 2003, the Dogs outperformed the Dow by about 3%, averaging a return rate of 14.3% annually whereas the Dows averaged 11%. The performance between 1973 and 1996 was even more impressive, as the Dogs returned 20.3% annually, whereas the Dows averaged 15.8%. (Source: Investopedia)
Indian Context: This concept is relatively new in India, and I’m not aware of any historical evidence of how DOD strategy works on top 10 dividend yielding stocks in Sensex of Nifty. Examples of some high dividend yielding stocks from the Sensex are below:-
|Mahindra & Mahindra||1.24%|
Benefits of the Strategy
Easy to set up: The strategy involves limited effort of setting up top 10 dividend yielding stocks just once in a year. The time involved can be just a couple of hours or at the most 2 days even assuming you are too slow in executing the strategy.
You don’t have to do anything once you set this up for one year. Regular buying, selling or monitoring the portfolio is minimal unless there is a significant change in the index which is quite rare or occasional. The whole process is automatic and requires no research or effort from your side. So this is ideal for investors who like to pick their stock but have less or no time for monitoring their stocks regularly. The only additional effort required is to keep a watch on change in index components whenever some stocks are removed from the Nifty or Sensex. In this case you have to remove these from your portfolio.
Benefits of Index stocks:
You have the comfort of investing in stocks that pass stringent tests before being chosen to be on the Nifty or Sensex. These companies are safe, have a good track record and have strong governance norms in place.
As per the current laws in India investors who sell stocks within a year have to pay the short term capital gains tax. Those holding stocks for over a year and selling or booking profits over a year pay no tax. You can implement the DOD strategy before the financial year ending March 31st year to make it easier when you sell some stocks after a year based on the strategy. Effectively speaking you can time your DOD strategy to match it with your financial year and tax planning requirements. (Please consult a tax advisor or chartered accountant for more details of the current tax laws. You should also cross check some of the information and facts here as laws change from time to time).
If the Dogs of the Dow strategy was the best and fool proof, then everyone would use it effectively and make decent returns year after year. There is no strategy that can guarantee results or provide a fool-proof stock picking strategy for equity investing, because equities as an asset class are bound to have risk and can give jitters to even the most experienced investors. Moreover, investing is not a perfect science, and has an element of art and intuitive side to it as well.
This combination of subjective and objective elements makes equities all the more complex and difficult to understand for normal investors. I am not contradicting myself, but just trying to tell you that the DOD strategy is a tool/framework that helps you control risk and fetch decent returns. It is important for investors to use or implement the tools effectively to enjoy the fruits of their efforts for a long term.
Disclaimer: Please use this article for informational or knowledge purposes. This is not an advice for tax or investment planning. Tax laws and investment scenarios can change from time to time. Hence, please consult your financial advisor or tax consultant before taking any decisions. We are not recommending this strategy for you and would not be responsible for any loss or unfavorable outcomes resulting out of actions taken based on this.