Contrarians' Day: Unleashing the Dow Dogs - TheStreet

If everyone else jumped off a bridge, would you?

When it comes to investing, the answer is probably yes. But there's a perfectly good antidote to buying high and selling low, and it's most likely something your mother never told you: contrarian investing.

Contrarian investing is a simple way to benefit from investors' tendency to be most optimistic when the market is peaking and most pessimistic when the market is bottoming. In his seminal

Stocks for the Long Run

, Jeremy Siegel lists contrarian investing first in his section on "return-enhancing strategies," citing evidence that "contrarian strategies of increasing stock exposure when most investors are bearish and decreasing exposure when they are bullish can improve long-term returns."

Of course, contrarian investing means different things. For some, it means buying out-of-favor stocks. For others, it means running like hell from an overvalued market. Today's Financial Education column will discuss a more moderate contrarian approach: The Dow 10 strategy, also known as the Dogs of the Dow.

The strategy is simple: Buy equal amounts of the 10 highest-yielding stocks among the 30 components of the

Dow Jones Industrial Average

and hold them for a year. At the end of each year, rebalance the portfolio to reflect the new top-10 highest-yielding Dow components. Among the Dow 10 currently:

Philip Morris

(MO) - Get Report


SBC Communications



J.P. Morgan Chase

(JPM) - Get Report


The strategy offers several virtues these days. First off, it has a built-in method for picking down-on-their-luck stocks. A stock's dividend yield is determined by dividing the amount of a dividend per share by the stock price -- when a stock falls, the yield rises. That's how the strategy got its name: Stocks that make up the Dow 10 tend to have been dogs over the past year, hence pushing up the yield.

In addition to the contrarian benefits, the recent dividend-tax cut makes the strategy more alluring. The average yield on the current Dow Dogs is 4.03%. In other words, if an investor put $10,000 in a Dow 10 portfolio, the stocks would pay out $403. Since the tax on dividends was pared to 15% -- barring state and local taxes, of course -- investors get to keep more of the dividend.

The strongest selling point for the Dogs of the Dow strategy: It has worked. In his excellent book

How to Retire Rich

, Bear Stearns Asset Management's James O'Shaughnessy explained that a $10,000 investment in the Dow Dogs in 1952 would be worth $6.6 million by 1996, compared with $1.7 million for the same investment in the

S&P 500


The Fine Print

Of course, like any other investing system, the Dogs of the Dow isn't perfect. The Dogs portfolio trailed the broader market in the heyday of the go-go late 1990s. And while the 12.2% loss for the Dogs in 2002 easily bests the 23.9% loss on the S&P 500, it also demonstrates that the portfolio can lose money.

Another risk is that dividends can be trimmed or eliminated. Companies such as

General Motors

(GM) - Get Report

and Altria face operating challenges that may force them to cut their dividends. Indeed, studies have demonstrated that companies offering slightly higher yields do better than the highest-yielding stocks over the long haul.

Why? Because many of the highest-yielding stocks have huge operating problems. One of the strengths of the Dow Dogs strategy is that, presumably, companies included in the Dow Jones Industrial Average are more durable than the broader stock universe -- but that hasn't always prevented collapses.

That brings us to another downside to the strategy: The stock might tank. "A 10% drop in a stock one day can wipe out a year's worth of dividends," said Michael O'Higgins, founder of O'Higgins Asset Management in Miami Beach. "Sure, that drop will get you a higher yield, but it doesn't help much when the stock is tanking." The name O'Higgins may sound familiar; his 1991 book

Beating the Dow

helped popularize the Dogs of the Dow strategy. However, O'Higgins doesn't recommend the strategy now because he believes the market is entirely overvalued and that the economy is headed for a depression. We'll discuss more dire contrarian strategies that O'Higgins and others espouse -- think

Newmont Mining

(NEM) - Get Report

, for starters -- in future Financial Education columns.

The dividend yield on the Dow industrials has trickled higher in recent years, but it still remains low by historical standards. The current average yield of the Dow industrials is 2.35%, compared with a median yield of 4.54% from 1871-2001. This is partly to blame on new additions to the Dow such as


(MSFT) - Get Report



(INTC) - Get Report

that don't offer much in the way of dividends -- if anything. But it has more to do with the fact that dividends have been declining in popularity for decades, reaching a nadir in the late 1990s. Investing based on dividend yields, while better than in recent years, doesn't offer as much bang for the buck as it used to.

Lastly, investors aren't getting a ton of diversification by buying these 10 stocks, most of which fall under the large-cap value category. If you don't have a ton of money to spread your assets around, the Dogs might not work for you.

Two Ways to Play

Investors eager to give the Dow Dogs a try have two solid options. The first: Get a discount broker and buy the 10 stocks outright.

While buying individual stocks can be costly, discount broker Scottrade lets you buy stocks for $7 a trade -- and doesn't hit you with inactivity fees and other subtle money-drainers that other brokers do. For about $70 a year, an investor can run with the Dow Dogs -- that's 0.7% for a $10,000 portfolio.

Investors who would rather have a manager do the work for them can check out the

(HDOGX) - Get Report

Hennessy Total Return fund, ticker symbol HDOGX. The fund basically apes the Dogs of the Dows strategy -- it owns 14 Dow components offering high yields. The strategy has worked: Its three-year average annual return of 5.68% ranks in the top 5% of all large-cap value funds, according to Morningstar.

The 2.33% expense ratio is pretty steep, well above the 1.39% expense ratio of the average fund. However, the fees come in below those levied by unit investment trusts that track the Dow Dogs -- expenses here can run north of 3%.

Well, that's a decent introduction to this contrarian strategy. But there are many nuances to Dow Dogs -- including modified versions such as the Dow Five. For investors looking to delve deeper into the Dog Pound, check out the stellar

Dogs of the Dow Web site.