5 Dow Dogs That Could Stomp the Market in 2013

BALTIMORE ( Stockpickr) -- That stock's a real dog -- better buy it!

As the Dow Jones Industrial Average pushes through to new highs in 2013, investors are left with a problem: Stocks are going up in general, but what still makes sense to buy now? The "Dogs" offer a solution.

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For the last two decades, the " Dogs of the Dow" has been one of the most widely circulated investment strategies out there, offering a individual investors with simple formula to beat the market: Simply buy the 10 highest-yielding Dow stocks at the start of each year, and hold on. So should you be buying the dogs in 2013?

When Michael O'Higgins introduced his strategy in 1991, it took the market by storm. Backtesting showed that the Dogs of the Dow strategy significantly beat the broad market from the 1920s on. The justification was that the big names of the Dow don't kowtow to market conditions, so their high dividends reflect strong businesses trading cheaply. But the strategy got a black eye during the 1990s, when it trailed the market by a significant clip.

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It shouldn't have been a huge surprise that the Dogs of the Dow failed to beat the market during the bull run of the 1990s. During the tech bubble, staid Dow names couldn't possibly move as much as the more volatile tech names that were gaining increasing weight in market indices. While some market watchers have written off the Dogs strategy as a case of data mining bias gone awry, the fundamental argument for buying high-yielding Dow stocks negates at least part of that argument.

That's especially true in the zero-rate environment we're in now.

My own research shows that paring down the Dogs of the Dow to a more concentrated portfolio of five stocks, rather than 10, has delivered some stellar outperformance in the last decade. So today, we'll take an analyst's look at the five Dogs of the Dow stocks.

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Up first is AT&T ( T), the highest-yielding Dow component. AT&T's payout currently weighs in at a hefty 4.8%, even in spite of the 18% rally that investors have enjoyed over the course of the last year. That dividend instantly adds considerable upside to this telco's capital gains.

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While most analysts like to call AT&T the nation's second-biggest cellular phone carrier, it's a bit of a misnomer. Even though chief rival Verizon ( VZ) boasts millions more customers, VZ only owns 55% of its cellular carrier subsidiary. AT&T, on the other hand, lays claim to all of AT&T Mobility and its 92 million cell phone subscribers. While AT&T's cellular business may have more visibility, investors shouldn't forget about the firm's legacy fixed-line business. Those landlines provide significant cash flows, and the infrastructure offers a reasonably deep economic moat.

Ultimately, cash is king for a huge dividend payer like AT&T. The firm generates around $20 billion a year in free cash flows, or double what it needs to cover its dividend payouts. That combination of financial strength and a big yield should bode well for investors this year.


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Even if Verizon isn't truly the nation's biggest cellular phone stock, the firm's partly owned mobile unit is still the dominant brand in the market -- and the $138 billion telco's 4.25% dividend yield makes it the second Dow Dog on our list. Verizon's business is almost identical to AT&T's: It's a mobile phone provider, it owns a robust fixed-line business, and it competes in the "bundle" space, offering consumers services like internet and TV.

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One key difference comes in fixed lines, where Verizon has been spinning off its legacy infrastructure portfolio to bankroll its costly FiOS installations. FiOs isn't cheap (some estimates put CapEx costs at $4,000 per installed home), but it's the future of residential and commercial connectivity. By biting the bullet on infrastructure spending now, Verizon gains a dramatically better network than peers as well as a more salable, sticky product.

Verizon's wireless business is the big variable that the firm needs to figure out. Vodafone ( VOD) owns close to half the business, and Verizon wants to buy it. That would be a good use of some of VZ's balance sheet liquidity in the near-term. In the meantime, an emphasis on shareholder yield has been another good use of the huge cash flows that VZ throws off. With a big defensive bent, investors could do worse than these two telco names in 2013, even if they're lacking in diversification.


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Hewlett-Packard ( HPQ), on the other hand, smells a bit like a value trap. The $42 billion tech firm has long been one of the leading PC manufacturers, but that business has become so commoditized in recent years that H-P was forced to find an alternative mainstay. Like most PC-makers, H-P chose the enterprise IT business as its new go-to.

Today, more than half of H-P's operating profits come from its enterprise customers, with the balance spread across a handful of other business units (like printers and services). That about-face from this firm's computer manufacturing past is impressive, but revenues are still getting weighed down by intense competition. That's sparked considerable speculation that HPQ could be due for a dividend cut in 2013.

Despite the headwinds in this stock, how much everyone else hates it may be the best reason to like it. Just look at relative strength. Shares are up more than 50% year to date, and HPQ is continually stomping the broad market as it bounces back from an oversold position. If you decide to follow the Dogs of the Dow playbook and buy HPQ, I'd at least recommend keeping a tight stop loss in place.


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Another tech stock on our abridged Dogs of the Dow list is Intel ( INTC). As the standard bearer in the computer processor business, the firm books around 80% of global microprocessor volume, manufacturing the "brains" behind the vast majority of computers coming off of assembly lines. But in the entire semiconductor market, there's still considerable room for growth -- especially given the ballooning demand for chips that power mobile devices.

While firms such as Hewlett-Packard see their margins get eaten away by commoditized PC prices, Intel is still managing to hold strong with hefty net profit margins that approach 20%. PC-makers may be fighting for share with price tags, but they're effectively all buying their chips from Intel. The huge turnover in the mobile device market -- both phones and tablets -- is a huge opportunity for Intel right now. While Intel is the underdog in the mobile space, that just means that there's room for the firm to materially grow its top line.

Intel is another cash-generation machine. The firm's free cash flow easily covers the 4.02% yield that shares currently pay out -- and leaves enough dry powder to spare to keep liquidity at strong levels. Right now, the firm's balance sheet sports approximately $10 billion in net cash, or around $2 per share. That gives Intel an after-cash P/E ratio of 9 right now.

That's a cheap tech stock any way you slice it.


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Pharmaceuticals have been high-yield names in the last few years, especially as the approaching patent expiration cliff sent share prices down to discount levels. Merck ( MRK) has been no exception; the $133 billion pharmaceutical maker currently pays out a 3.9% dividend yield.

Merck lost patent protection on its blockbuster asthma drug Singulair this year, a big blow to the firm to be sure. But investors have been bracing for the impact of patent expirations, and strategic moves such as the 2009 acquisition of Schering-Plough give Merck the late stage pipeline it needs to help replace that revenue loss. As I write, nearly half of the firm's sales come from the domestic market. And that's a very good thing right now considering the resilience of the U.S. dollar (that effectively penalizes overseas earnings) and the impact that "Obamacare" will have on pharmaceutical volumes in the next few years.

A balance sheet that carries a nearly $3 billion net cash position gives Merck ample dry powder to get opportunistic with mergers and drug acquisitions in 2013. If the Singulair patent loss plays out to be less dramatic than anticipated, investors could lessen the discount on patent expirations going forward. That would be a very good thing for shareholders this year.

To see these stocks in action, check out the at Dogs of the Dow portfolio on Stockpickr.

-- Written by Jonas Elmerraji in Baltimore.


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At the time of publication, author had no positions in stocks mentioned.

Jonas Elmerraji, CMT, is a senior market analyst at Agora Financial in Baltimore and a contributor to TheStreet. Before that, he managed a portfolio of stocks for an investment advisory returned 15% in 2008. He has been featured in Forbes , Investor's Business Daily, and on CNBC.com. Jonas holds a degree in financial economics from UMBC and the Chartered Market Technician designation.