Two years ago, I introduced Forbes readers to the “Dobermans of the Dow.” The Dobermans are my version of the “Dogs of the Dow” strategy, which Michael O’Higgins popularized via his 1991 book, Beating the Dow.

Using O’Higgins’ approach, investors will typically buy the ten stocks from the Dow Jones Industrial Average (DJIA) with the highest dividend yields at the start of each year.

My approach, on the other hand, focuses on two different variables.

Step 1: Rank Dow constituents by Return on Equity (ROE), keeping the top 20. 

Step 2: Rank remaining names by Free Cash Flow Yield, keeping the top 10.

Those final ten names are your Dobermans.

The Dobermans of the Dow outperformed again this year, consistent with the historical trend. The 2019 Dobermans generated a total return of 29.6% compared to 25.3% for the Dow.

Source: Bloomberg

 

Here is a look at relative performance, since I first introduced the Dobermans screen at the beginning of 2018.

 

Investors have been following the Dogs of the Dow strategy for decades, which is a remarkable achievement. Investing fads come and go like stars in Hollywood—most are just a flash in the pan. Few have staying power.

Will the Dobermans have staying power?

The only certainty in investing is uncertainty. And I’m sure there will be future years when the strategy falls short. It’s inevitable.

That said, I’m optimistic the Dobermans of the Dow is a strategy individual investors can pursue with confidence for years to come.

Several factors lead me to that conclusion.

1) Historical performance. If you’re not backtesting your investing process, you’re guessing, which is equivalent to gambling. It’s really that simple.

We all know the past doesn’t perfectly repeat itself. But wouldn’t you rather have history on your side instead of working against you? Especially if you’re putting your life savings on the line?

Encouragingly, past performance is on the Dobermans’ side. The Dobermans have outperformed the DJIA in 18 of the last 22 years, averaging a 14.4% annual return. The cumulative return of this simple, 10-stock portfolio is +1,227% versus +502% for the Dow.

Source: Bloomberg

 

2) Markets are not perfectly efficient. Even huge, widely followed companies populating the Dow can become mispriced.

For instance, the following table shows the annual trading range of last year’s Dobermans. The average percentage change between the 52-week high and low was 46%. Did the underlying value of these massive enterprises really change that much?

Source: Bloomberg

 

If the market were perfectly efficient, the answer would be yes. But it’s a tough sell when you consider the underlying dynamics. Market prices are more volatile than underlying business fundamentals.

Apple is the most glaring example. At the stock’s nadir in January 2019, the market cap was around $675 billion. In less than twelve months, Apple’s market cap has swelled to $1.3 trillion. The $625 billion swing exceeds the value of Walt Disney, Pfizer and IBM combined.

Did the folks in Cupertino really create more value this year than those three corporate behemoths did over their entire histories? Probably not.

Interestingly, 2020 will be the first time since 2015 Apple fails to qualify as a Doberman.

3) Fundamental advantage. Unlike a lot of equity strategies, the Dobermans have outperformed across numerous style cycles. That is likely because the screen mixes growth and value factors in the selection criteria.

In my original article about the strategy, I said, “The Dogs of the Dow strategy only asks one question: how cheap? And it makes a narrow comparison in delineating that by only considering dividend yields.”

Takeaway: the Dogs of the Dow is basically a value strategy.

I also wrote, “The Dobermans of the Dow is a better companion tool for investors, because it’s more dynamic. It starts by sorting Dow constituents by a quality metric (ROE). Then, among those higher quality names, it compares prices in a more universally applicable way (FCF yield)."

A fundamental truism is that quality and valuation both impact an investor’s “margin of safety.” Keeping that in mind, the probability of an individual investor achieving a very poor result following the Dobermans strategy is low.

• All the Dobermans are large, world-class businesses.
• The average ROE for the 2020 Dobermans is 30%; effectively double the S&P 500.
• The average FCF yield for the 2020 Dobermans is 6.5%, whereas you get a 3.8% yield buying an S&P 500 index fund (source: Bloomberg).

So, if you view the Dobermans as a “conglomerate,” you own a diverse mix of mega firms, with above-average profitability, whose shares are relatively cheap compared to the cash they generate.

Hardly a recipe for disaster.

You can reduce the number of unforced errors in your portfolio by favoring high-quality businesses that earn high returns on capital. For more on this subject, I encourage you to read Warren Buffett’s 1987 Letter to Shareholders.

If you want to learn more about why free cash flow yield is a useful metric, I recommend checking out this post by yours truly.

Now, let’s meet the 2020 Dobermans of the Dow. Good luck in the new year!

Source: Bloomberg

 

Originally published by Forbes. Reprinted with permission.

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Disclosure: I own IBM, WBA, AXP, CSCO, VZ, INTC, MMM, PFE, JNJ and CAT in accounts I professionally manage.​ This material is not intended to be relied upon as a forecast, research or investment advice. The opinions expressed are as of the date indicated and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by Silverlight Asset Management LLC to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by Silverlight Asset Management LLC, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any of these views will come to pass. Reliance upon information in this post is at the sole discretion of the reader.​​  ​