Dow 20,000 is all anyone can talk about lately even though most people follow the S&P 500 more closely as a market proxy. And the milestone seems to be drawing closer; the market gave back some gains in the last few days of 2016 but investor enthusiasm for stocks is still looking up in the new year.
The Dow, a price-weighted index of 30 stocks, is one of the oldest in the country and dismissed by most investors as being too narrow to represent the economy. But savvy investors know the Dow can be used as a powerful trading signal, confirming signals in the market. The index has also given rise to one of the most popular investing strategies, one that has consistently beaten the broader market.
A Simple But Effective Strategy
Charles Dow and Edward Jones created two of the first stock market indices in the mid-1880s, publishing the groups of stocks in a financial newsletter that would later become The Wall Street Journal. The Dow Jones Transportation Average was created first, a group of 12 stocks to measure the health of the American transportation sector. The Dow Jones Industrial Average (DJIA) was created next with 12 stocks to represent the industrial might of the flourishing country.
Since that time the DJIA, colloquially called the Dow, has grown to 30 stocks. The index is no longer strictly industrial companies but includes some of the largest U.S. companies in several sectors.
The Dow Theory compares rallies in the Dow Jones Industrial Average and the Dow Jones Transportation Average to confirm the stability and direction of the stock market. The idea is that a price rally in industrial companies and other large firms should be confirmed with a rally in transportation companies, the companies that will benefit from increased need to ship those new industrial orders.
If the Dow rallies without higher prices in the transportation stocks as well, this signals that the market may fail to keep its gains. If both indices march higher, the market trend is confirmed and prices may keep rising.
The 30-stock Dow has also given rise to one of the simplest stock-picking strategies you'll ever find and one that has consistently beaten the broader market. The "Dogs of the Dow" strategy targets the highest yielding stocks in the DJIA each year.
Investors buy the ten stocks with the highest yield in January, buying equal amounts of each and hold them through the year. It's surprisingly simple but has beaten the stocks in the S&P 500 by 1.7% annually over the last decade.
Another variation of the Dogs strategy is the Small Dogs of the Dow, the five highest yielding stocks within the group of thirty. This strategy has outperformed the S&P 500 by 2.7% annually over the last decade.
There's an intuitive reason why the Dogs frequently beat the market. Since the dividend yield is just the dividend divided by the price, high yields either mean price weakness or a cash payments that have jumped faster than price gains. Quickly growing cash payments are obviously a great signal that management believes cash flows will remain strong.
A higher dividend yield on weakness in the shares is worrisome but these mega-cap companies generally have the financial power to survive any short-term weakness and, in any case, investors are compensated handsomely with high yields while they wait for a rebound.
2017 Small Dogs For Your Portfolio
The five small dogs of the Dow pay an average dividend of 3.8%, nearly twice as much as the yield paid by stocks in the S&P 500. Each is a leader in its sector, providing a diversified mix of stocks with great cash return and price potential.
Verizon Communications (NYSE: VZ) pays a 4.3% dividend yield and trades for just 13.9 times trailing earnings. The company is the largest wireless carrier in the United States, serving 113 million customers with coverage over 95% of the country. While fixed-line customers still account for 25% of sales, the company is able to bundle with its Fios internet, telephone, and television to lower prices and compete against cable operators. Free cash flow of over $11 billion is more than enough to cover the $9 billion annual dividend with cash left for share buybacks.
Pfizer (NYSE: PFE) pays a 3.9% dividend yield and trades for just 13.3 times trailing earnings. Shares have been basically flat over the last year as the company works through some patent expirations including the 2017 expiration of Viagra but new drugs should start to fill the gap. The 2009 acquisition of Wyeth helped to diversify the company away from relying on individual drugs and several recently launched drugs for breast cancer and rheumatoid arthritis could be blockbusters.
Cisco Systems (Nasdaq: CSCO) pays a 3.4% dividend yield and trades for just 12.7 times trailing earnings. The company is the global leader in networking equipment with a market share lead of 15% over its next closest competitor. Industry transition to cloud services has weighed on sales growth over the last few years but the company now books a third of sales in faster-growing segments such as wireless, security and cloud services. Increasing growth in data networking needs on internet of things (IoT) products could drive Cisco sales even in a competitive environment.
Chevron Corporation (NYSE: CVX) saw earnings sink last year on weakness in oil prices and restructuring charges. Earnings sank to $0.99 per share over the last year and the stock is trading for a multiple of 119 times. Earnings are expected to surge to $4.66 this year, bringing the multiple back down to 25 times and profits are expected to rebound over the next few years.
Shares pay a 3.7% dividend and the company should see development of several large liquefied natural gas (LNG) projects in Australia add to cash flow soon. The company is diversified across upstream exploration and downstream refining which helps it offset weak oil prices with better refining margins.
Boeing (NYSE: BA) pays a 3.7% dividend yield and trades for just 24.3 times trailing earnings. Boeing books 70% of orders from commercial buyers and the rest on orders for defense, which should do well on higher defense spending over the next few years. The company has back orders of 5,600 commercial planes, representing nearly a decade of production, and has returned $7.2 billion to investors over the last four quarters through the buyback. Despite recent comments over pricing by President-Elect Trump, the company should benefit on the new administration's preference to U.S. manufacturing.
Risks To Consider: The Dow is a fairly limited index composed of just 30 stocks, so any investing strategy is going to be limited as well.
Action To Take: Check out the Small Dogs of the Dow strategy to invest in inexpensive, high-yield stocks with the potential to outperform the broader market.
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This article originally appeared on StreetAuthority.com: "Investing For Dow 20K And Beyond"