6/26/08

Is It Time to Start Buying Some Dogs?

We all know the motto that tells us to invest when everyone else is fearful and to sell when everyone else is optimistic. We also know that over time, the market's tendency is to go up, not down. The Dow Jones Industrial Average, one of our three principal market barometers, is down around levels unseen since September 2006.

The erstwhile popular Dogs of the Dow strategy has averaged an annual return of 17.7% from the period 1973 through 2006. It hasn't done as well the last couple of years, but all investing strategies have their bad years. For those who have never heard of it, the strategy is very simple. At the start of the year, find and buy the ten highest yielding DJIA stocks (the dogs as they're called). Keep them for a year and a day, find the new list of the highest yielding DJIA stocks, and repeat. The idea is that you can evaluate large cap stocks based on their yields. The larger the yield, the more likely it is that the market is undervaluing the stock.

Here are the Dogs of the Dow, with their yields as of market close on 6/26/08:

Bank of America (BAC) 9.6%
Pfizer (PFE) 7.2%
General Motors (GM) 7.6%
Citigroup (C) 6.8%
Verizon (VZ) 4.9%
AT&T (T) 4.7%
General Electric (GE) 4.5%
Merck (MRK) 4.1%
JP Morgan Chase (JPM) 4%
DuPont (DD) 3.7%

Look at those yields! If the DJIA contains the best companies and the market over the long term tends to go up, aren't these dogs a steal? Maybe it's time to start buying a few shares here and there while everyone else is selling in this climate of fear?

I'm a bit skeptical for most of these. One common variation on the Dogs of the Dow strategy is to avoid the highest yielding stock, as it's usually the one facing the worst problems. But take a look at the top four.

Bank of America's CEO has recently stated that the dividend is safe. I don't know if I believe him. This one could turn out to be a great investment, but who knows how many subprime write-downs they have left? I'd stay away from this one.

Pfizer has its own dividend cut rumors. It also faces expiring patents on its most profitable drugs, like Lipitor (although it did recently buy an extra five months on that one).

General Motors was downgraded to a sell by Goldman Sachs, sending its shares to 53 year lows. High gas prices, the tight credit market, and the housing crisis are likely to continue to weigh on what was once a great American automaker.

Citigroup appears to be in even worse shape than Bank of America. It was just downgraded to sell by Goldman Sachs, which expects the struggling bank to post a $9 billion write-down in the second quarter. Citi's current yield of 6.8% belies its 41% dividend cut back in January of this year.

Verizon seems to be a better prospect. If the deal to buy Alltel goes through, Verizon will be the largest wireless provider in the US. While analysts have been concerned with the deal's price tag, the acquisition should add to Verizon's bottom line as soon as it's completed. Verizon's fixed line business, for services such as land-line telephone and DSL, also has some potential. Although landline phone use is declining and Verizon faces mounting competition from other internet providers, over the next few years the firm is poised to pick up millions of new customers (over two million a year). I don't think it's unreasonable to start picking up a few shares of this dog--but not a full position, we may be entering a bear market.

AT&T is also having some land-line troubles, as well as wireless successes. The company continues to cut costs. It has slashed over 14,000 jobs over the last three years. The firm's balance sheet is relatively clean, and it continues to buy back shares. AT&T hopes the culmination of its network upgrades, U-Verse, which is set to be deployed in 2010, will attract more customers. AT&T also has a deal with Apple (AAPL) for the new iPhone, which should also bring in new customers. As with Verizon, this stock may certainly go lower, but this doesn't seem to be a bad time to start picking up shares.

I think GE is being unfairly punished by the market. With most of its sales coming from abroad, its various footholds in emerging markets, and its alternative energy and water infrastructure businesses, I think the company has a bright future. This is not to say that the firm does not have problems (NBC Universal, GE Capital). Still, this sleeping giant is ready for some solid earnings growth in the future. If it falls lower, I'm looking to pick up some more shares.

Like Pfizer, Merck has some considerable challenges ahead of it. These include patent expirations on some of its biggest selling drugs (e.g., Singulair, Fosamax, and Cozaar) and increased competition in the near future on drugs it currently holds a monopoly over (e.g., Gardasil and Januvia). Merck also faces billions of dollars in potential liability from continued Vioxx lawsuits. Added to this, the FDA has rejected a number of the company's new drugs. A few drugs in the pipeline have similar chemistries, so they are likely to also be rejected. While the short term prospects are not too bad (until Glaxosmithkline starts selling alternatives to Gardasil and Januvia), the long term seems gloomy. In a couple of years, Merck might be in the same position Pfizer is in today.

Like the other financials, JP Morgan Chase has some difficulties. Losses stemming from home loans are likely to continue, and may even accelerate by the end of 2008. As the economy continues to slump, people use their credit cards less. They may also have trouble paying what they owe. This is likely to hamper Chase's earnings. At last count, the bank has over $20 billion in risky assets, and who knows what it's going to get when the Bear Stearns deal closes. There are some positives, though. The firm's retail banking division is growing. Its balance sheet also seems less affected by the subprime mess than those of its DJIA banking counterparts. Eventually financials will be great buys. Maybe the time to start picking up shares is now, but I'm not even tempted to do it.

DuPont, like GE, seems to be another stock being unfairly punished by the market. While its housing exposure is dampening profits, the firm has the world's second largest seller of seeds. There is a food crisis, and DuPont is well positioned to profit from it. I think much of my reasoning for buying it in December of last year still holds true. I'm certainly glad I subsequently sold it, but I think it'll soon be a good time to buy it back.

That's all the dogs. I think the financials are too scary, as are the drug makers and GM. I feel better about T and VZ, and I like DD and GE.


Disclosure: At the time of writing, I owned shares of GE. I also own shares of BlackRock's Enhanced Dividend Fund, which owns shares of AT&T, Bank of America, Citigroup, JP Morgan Chase, Pfizer, Merck, and Apple (not a Dog of the Dow). I most likely own the rest of the dogs through the fund, but they are not in its top 25 holdings.