This ‘small dogs’ strategy is one way to find incredible dividend yields

  • By Al Root,
  • Barron's
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Investors seeking higher yields might want to consider Small Dogs.

No, this isn’t a bizarre recommendation about a burgeoning alternative asset class. Instead, it is a modification of a time-tested investment strategy: the Dogs of the Dow.

The Dogs of the Dow strategy buys the 10 highest-yielding stocks in the Dow Jones Industrial Average (.DJI) each year. The strategy returned about 15% a year for the last decade, outpacing the broader index. What’s more, the Dogs of the Dow only trailed the index in three of the past 10 years.

It’s a simple strategy that has worked.

But ”The Dogs” refers to The Big Dogs. The average market capitalization for the 2020 Dogs of the Dow is about $180 billion. The average dividend yield is about 3.7%. And the stocks trade for, on average, about 15 times estimated 2020 earnings.

That dividend yield is attractive at almost two times the yield of the S&P 500 (.SPX). But there is more yield available in smaller stocks. And when you buy a portfolio of small stocks, some of the risks of holding often volatile small stocks is reduced.

Barron’s looked at the highest-yielding stocks in the small capitalization Russell 2000 index with a market value greater than $1 billion. Why $1 billion in size? It’s an arbitrary cut-off to try to ensure a real position in all the stocks listed can be bought.

Over the past 10 years, Barron’s Small Dogs earned about 14% a year on average, trailing the broader Russell 2000 (.RUT) by only about one percentage point a year, and a little better than the comparable return of the S&P 500.

That’s not a bad performance but there are some caveats. The Barron’s Small Dogs outperformed the Russell 2000 and the S&P 500 in four of the past 10 years. What’s more, the return of The Small Dogs was more volatile, year to year, than either broader index.

So why should investors take higher volatility for similar returns?

One answer is yield. The average dividend yield over the decade is almost 20%. Most of the return comes from dividends. And the Small Dogs strategy tends to work a little better when the starting dividend yield is high.

Entering 2020, the Small Dogs are yielding more than 20% on a trailing 12-month basis. The average dividend yield for the Russell 2000 is about 1.7%. That’s a huge gap.

There are a lot of real-estate investments and some special dividends mixed in when we look at this year’s 10 Small Dogs. But Barron’s doesn’t adjust for anything. That’s the beauty of a simple strategy. It’s easy to implement.

Barron’s 10 Small Dogs for 2020 are: Warrior Met Coal (HCC), Diversified Healthcare Trust (DHC), New York Mortgage Trust (NYMT), Armour Residential REIT (ARR), The GEO Group (GEO), Vector Group (VGR), Werner Enterprises (WERN), Invesco Mortgage Capital (IVR), Office Properties Income Trust (OPI), and Global Net Lease (GNL).

The median valuation ratio of the 10 Small Dogs is about 10 times estimated earnings. The average market capitalization of the group is about $2 billion.

Before going out and buying Small Dogs, investors need to ask themselves how they feel about volatility. Everyone’s tax situation is different, making the impact of dividends different for each investor. Still, the Small Dogs strategy is one way to reach for more yield in a market that doesn’t seem to offer much.

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