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Dogs of the Sensex: A great stock picking strategy
July 31, 2007 15:03 IST
In my quest to find the best stock picking system, I came across a very interesting strategy that is simple as well as convenient. To employ this strategy, you will require not more than two-three hours in a year. Yes, you heard that right.
I like to call this strategy Dogs of the Sensex, based on the Dogs of the Dow theory made famous by Michael O'Higgins.
Dogs of the Dow is one of the most popular 'mechanical' investing techniques. It takes all of the research, strategy and guesswork out of investing. In fact, it will only take up two-three hours of your time each year.
Like the BSE Sensex is the benchmark index for the Indian stock markets, the Dow Jones Industrial Average, DJIA, is the benchmark index for the US stock markets. A benchmark index consists of stocks that represent various dominant sectors of a country's economy.
As unreal as that sounds, this technique has been around since the early 1990s, when Michael O'Higgins introduced it in a book.
Here's how it works
~ Once each year, you look at the 30 stocks in the Sensex and pick the 10 with the highest dividend yield.
Dividend yield is the dividend amount per share divided by the share price.
For example, a dividend yield of 3 per cent means that a share that costs Rs 100 would pay a dividend of Rs 3.
A high dividend yield is seen as an indication that a stock is under-priced. A low dividend yield indicates that the stock is over-priced.
According to the Dogs of the Dow theory, such stocks are the best candidates for a jump in their prices. You invest an equal amount in each of these 10 stocks, and then wait for a little more than a year.
~ After one year, you look at the Sensex again. You sell the stocks that are no longer in the top 10 by dividend yield (the 10 stocks that you had picked earlier will not be there because their price will have risen or because a few of them might have been removed from the Sensex. A committee that looks into the composition of Sensex changes the stocks that form the Sensex on a regular basis).
~ You replace them with the stocks that now make the top 10 list by dividend yield (they will be there because their prices would have fallen or they are new entrants in the Sensex).
~ Important note: Make sure you hold the stocks you buy for one year and one day. If you hold and sell your stocks after a day more than a year, it is considered as long-term capital gain. In India, long-term capital gains are not taxed at all. Any gains that you make by buying and selling a stock/s within a year is considered as short term capital gains and is taxed at 10 per cent.
This strategy needs you to rebalance your portfolio after a year and a day. This is because the stocks with high dividend yields that you had picked the previous year may not remain the top dividend yielding stocks after a year.
The strategy WORKS and how!
As mentioned earlier, one of the big attractions of the Dogs of the Dow strategy is its simplicity; the other is its performance.
From 1957 to 2003, the Dogs outperformed the Dow by about 3 per cent, averaging a return rate of 14.3 per cent annually whereas the Dows averaged only 11 per cent.
The performance between 1973 and 1996 was even more impressive, as the Dogs returned 20.3 per cent annually, whereas the Dow averaged 15.8 per cent.
More than the performance of this strategy in the US market, the other reason it will work is due to the assumption on which the entire strategy is based.
Do things the smart way
The base of this investment style is that the Dow laggards, which are temporarily out-of-favor stocks, are good companies because they are included in the index (if they were not, then they would not be a part of the Dow or for that matter the Sensex, in the first place); therefore, holding on to them is a smart idea, in theory.
Once these companies rebound (that is, the price of their stocks increase) and the market has revalued them properly, you can sell them and renew your portfolio with other good companies that are temporarily out-of-favor but the potential of a high dividend yield.
Furthermore, because there is a committee perpetually tinkering with the index like the Sensex, you can rest assured that the Sensex or any other index is made up of good, solid companies.
Investing in dividend dogs of the Sensex is similar to the strategy of `Dogs of the Dow' followed in the US.
In the US, the strategy involves investing in the high dividend yielding stocks that are part of the Dow Jones Index. The strategy has been found to beat the market consistently in the US. Adaptations of the strategy in the UK and Canada [Images] have also delivered index-beating returns.
Caution is the key once again
This strategy, like any other stock picking strategy in the world, is not foolproof. It cannot save you from the losses during recessions; it can at the maximum minimise your losses. The key to this strategy is that it can beat the Sensex return over a long term; at the same time, it gives you the benefit like that of a fixed deposit.
If you are looking for a mechanical, non-emotional way of investing in the stock market, the Dogs of the Sensex may be your answer. This strategy removes out the judgment required in the stock market, replaces it with cold calculation and brings sanity in our investing.