Dogs of the Dow's 'Mutts' Have No Bite

NEW YORK ( TheStreet) -- At the beginning of every year, proponents of the "Dogs of the Dow" investment strategy trot out the 10 highest-yielding stocks in the Dow Jones Industrial Average and suggest buying them as a means of beating the market.

Although every dog has its day, there are always some perennial losers in the pack, in terms of return on investment, so strictly hewing to that strategy has its faults.

For example, 2010 was the first year since 2006 when the Dogs' return outdid that of the Dow, excluding dividends. The group has only done it three times in the past eight years, and only in 2006, when the Dogs returned 30% vs. the 19% of the Dow, was it a blowout victory.

But 2010 was also a very strong year for the Dow Dogs' strategy, as the group returned an average 16.3%, while the blue-chip index returned 11%.

The average 3.87% yield the class of 2010 paid in dividends also makes the Dogs of the Dow strategy worth considering.

But every year there are a couple of mutts among the Dogs that investors would have best avoided. Lately, they've been from the health care sector, one of the poorest-performing groups in 2010 with a return of 6.5%, which is next to last out of all investment sectors.

In 2010, the Dogs were held back by pharmaceutical giants Pfizer ( PFE), down 3.7% on the year, and Merck ( MRK), off 1.4%. A newcomer to the Dogs that's going on the list for 2011, health care products conglomerate Johnson & Johnson ( JNJ), was right in step, losing 4% in 2010.

And yet analysts are fond of these stocks because of their long-term prospects, which are built on the idea that a glut of baby boomers, now edging into retirement, will gobble an ever-increasing number of drugs as they age. The elderly currently account for about one-third of drug industry sales.

So we decided to look at the prospects for those three companies, as well as two of their competitors that face similar challenges.

Pfizer ( PFE), with a $140 billion market capitalization, is the world's largest pharmaceutical company and yet it has abysmal three-year and five-year share performances, averaging a 24% loss over each period, including a 3.7% decline in 2010, which indicates that buy-and-hold doesn't work here.

And yet analysts like this stock, as seven currently rate it buy, 10 buy/hold and five hold, according to Standard & Poor's. At the same time, they estimate that its earnings per share will grow a meager 3% to $2.29 in 2011, hardly anything to write home about. The stock also carries a price-to-earnings ratio of 23, about double that of most of its major industry peers.

On the plus side, Pfizer has a wide range of patent-protected drugs, and its top sellers are all aimed at aging baby boomers and current seniors, including cholesterol-lowering Lipitor, Celebrex for arthritis and Viagra for impotence. Given their protected status and the big margins drugmakers have, the company has a huge and steady cash flow.

About a year ago, Pfizer acquired rival drugmaker Wyeth for some $68 billion in cash and stock. The deal is expected to be substantially accretive to revenue and earnings. A Standard & Poor's analyst has a $20 price target on its shares over the next 12 months, which represents 13% appreciation to its current price.

Merck ( MRK) is another chronic underperformer with its shares down 37% over the past three years, including 1.4% in 2010. But analysts are bullish on it shares, giving them eight buy ratings, five outperforms and four holds, according to FactSet.

The once-stagnating company makes drugs to treat conditions in a number of therapeutic areas, including cardiovascular disease, asthma, infections and osteoporosis. Merck also has a substantial vaccine business, including vaccines for the prevention of hepatitis B, pediatric diseases and shingles.

The company's long-term prospects were revitalized by the $41 billion acquisition of competitor Schering-Plough in March 2009; that deal is what has turned analysts bullish. Merck took on $85 billion in debt to fund the transaction, but its huge cash flow -- an estimated $12 billion in 2011 -- should help pay that down relatively quickly.

In late October, the company said it expects full-year earnings of $3.35 per share for 2010. Analysts are currently estimating that earnings per share will grow by 13% to $3.80 in 2011. S&P analysts have a $42 price target on the stock, which represents a 16% premium to its current price.

Johnson & Johnson ( JNJ) ranks as one of the world's largest and most diverse healthcare companies with three divisions: pharmaceutical, medical devices and diagnostics, and consumer products, and it is one of the most respected brand names in its field.

But its stock has fallen 4.7% over the past three years, including a 4% decline in 2010. Analysts have a 12-month $65 price target on the shares, a modest 5% premium to its current prices. But its fundamentals are solid, including a diverse revenue base (each business represents about one-third of annual revenue), protected markets because of its many patents, and huge cash flow (more than $14 billion in 2009) that it uses to fund a robust research pipeline and make acquisitions.

The recent loss of patent rights on two of its big sellers -- the antipsychotic Risperdal and the neuroscience drug Topamax -- are seen hurting revenue in the near term Analysts expect a slim revenue increase from the current 2010 outlook of $62 billion, although emerging markets sales are growing rapidly.

Earnings per share for 2010 are projected at $4.75, which is expected to grow by 5% to $4.99 in 2011. Analysts' outlooks are confusing. A Standard & Poor's compilation finds three buys, 11 buy/hold and 10 hold ratings, while FactSet reports five buy ratings, six outperform and 11 hold. The company recently announced a $10 billion share-repurchase program. Shares rose 1.9% over the fourth quarter, a sign that investors may be responding to that.

Abbott Laboratories ( ABT), down 11.3% in 2010, makes and sells pharmaceuticals, medical devices, blood glucose monitoring kits and nutritional health care products.

Its products include prescription drugs, heart stents and nutritional liquids for infants and adults. And it recently entered the market for eye-care products with its acquisition of Advanced Medical Optics. Abbott generates about 60% of its revenue from pharmaceuticals; the variety of its offerings helps it ride it out industry cycles.

"Abbott maintains diverse businesses, which insulate it from the fluctuations inherent in pharmaceuticals," said Morningstar analysts in recent research. "As a result, despite some patent expirations, we think the firm can steadily increase revenue by an industry-leading 5% on average for the next 10 years."

For fiscal year 2010, Wall Street is looking for earnings of $4.17 per share with profits expected to grow 12% to $4.66 per share in 2011.

Abbott is another company that analysts like, but its shares are down over the past three years, in this case a decline of 13.8%. In its favor, the company has a 35%, three-year dividend growth record, leading to its current 3.8% yield, which should salve some wounds.

Wall Street is pretty bullish, with 13 of the 20 analysts covering the stock at either buy (eight) or outperform (five), according to FactSet, with the remaining seven at hold. A red flag went up in the third quarter, however, as institutional investors cut their holdings by 18%. The 12-month price targets of analysts range from $62 to $68, with the former representing a 29% premium to its current price.

Baxter International ( BAX) is another big pharmaceuticals player that doesn't get investors' respect, and its shares are down 13.8% over the past three years, including a 13% decline in 2010.

But it's not for lack of trying. Over the last five years, the company has returned more than $10 billion to shareholders in the form of dividends and share-repurchases. Baxter has doubled its dividend rate during this period and recently announced a 7% increase for 2011. And on Dec. 13, the company said its board has approved a $2.5 billion share repurchase program.

Analysts are upbeat on the stock, giving 11 buy ratings, two outperforms and five holds, according to FactSet. Its biggest market is as a developer of injectable therapies for a wide variety of medical conditions.

Revenue is expected to grow in the low single-digits from the current $13 billion estimated for 2010. New products and emerging markets are driving most of its increases. Its five-year earnings growth forecast of 10.7% is half that of its industry peers. For fiscal year 2010, analysts estimate the company will earn $3.98 per share and grow that by 7% to $4.24 per share in 2011.

Capital World Investors bought about 7.5 million shares in the third quarter to up its stake in the company to 6.6%, making it by far the largest investor. The current analysts' median 12-month price target of $58 represents a 15% premium to the stock's current price.

-- Written by Frank Byrt in Boston.

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