The "Dogs of the Dow" and the slightly less well-known "Dogs of the S&P" are stock-picking strategies focused on the Dow Jones Industrial Average and S&P 500.

At the start of each year, investors select the highest-yielding dividend stocks — usually the top 10 — allocate an equal amount of capital to each and rebalance annually by replacing stocks that no longer meet the criteria. This article is the first in a series of three covering trade ideas on these "dogs."

On its own, the "Dogs of the Dow" is an appealing strategy because it is simple and systematic. In some ways, it resembles a "CliffsNotes" approach to fundamental investing techniques. While simplicity is elegant, occasionally, it involves making assumptions that may or may not be valid. First, the "Dogs" approach assumes that the relevant index represents well-established "blue chip" companies.

Second, this tactic assumes that companies in the index with high dividend yields are only temporarily out of favor and likely to recover in price (revert to the mean), leading to both capital appreciation and solid income from dividends. Third, it assumes that the portfolio of perhaps only ten stocks is sufficiently diversified, even though the approach, by focusing on dividends, may introduce potential selection bias. 

Famous value investors Benjamin Graham and David Dodd agreed with this approach's key premise: One should adopt a contrarian mindset and bet on "unloved" stocks the market undervalues due to temporary setbacks, expecting the "mispricing" to correct over time. However, they did not simply determine which stocks were mispriced by looking at their dividend yield. Instead, they advocated a deep analysis of financial metrics, including price-to-earnings ratios, book value and intrinsic value, and the quality of the assumptions used to calculate them. 

By definition, underperforming stocks are out of favor, so screening in this way should avoid overbought stocks. However, stocks may fall due to deteriorating fundamentals, so we must impose additional screens. 

Key considerations for choosing unloved names

One criterion worthy of consideration is revenue growth. Over the past 10 years, S&P 500 revenues have grown by about 5.1% per year on average, consistent with the roughly 4.6% average nominal (non-inflation adjusted) gross domestic product growth over the same period. Naturally, revenues may fluctuate due to cyclical effects. Industries closely tied to commodity prices would be a good example. Still, if we can use a smoothing mechanism to estimate longer-term trends, we prefer companies that grow as quickly as the broader economy and inflation.

Another criterion that cannot be ignored is earnings and free cash flow growth. Earnings growing faster than revenues indicate high demand for a business's goods or services and limited competition. Conversely, if earnings are not keeping pace with revenue growth, that could indicate an industry is becoming more competitive, squeezing margins. It is OK that mature and competitive industries may have narrow margins — if they're stable — but narrowing margins can be more challenging to work with because it may be harder to project earnings in the future. 

In any case, a company with declining revenues, earnings and free cash flow may not even be able to sustain its current dividend, let alone grow it to keep pace with future inflation. Therefore, it should be viewed skeptically. To illustrate the flaws of focusing on dividend yields exclusively, consider the following table, which represents the top 10 highest dividend-yielding stocks in the S&P 500.

Notice that of these 10 stocks, only two have been growing as fast (or faster than) the economy, one of the criteria I mentioned. Put differently, the remaining eight are shrinking in real terms. The highest yielding stock, Walgreens, doesn't even carry an investment-grade credit rating, the lowest of which is BBB-.

Vici Properties and Crown Castle are both real estate investment trusts, which are obligated to pay out 90% of their taxable income to maintain that status. This explains their high dividends. Of the two, Crown Castle operates mobile towers, and although the company has seen long-term revenue growth, 2025 revenues are expected to decline for the second consecutive year. In short, simply picking the top 10 dividend yields in the S&P 500 provided us with only one interesting candidate, a REIT, Vici Properties.

The trade

Vici will not pay its next dividend of 43 cents per share until March, but if you want to collect one before then, one could consider selling a cash-covered put.

The February 27.5 puts, which are 4.5% out of the money, yield about 43 cents, or about 1.5% over the next two months. If the stock falls through that strike, one would own Vici at a roughly 6% discount to the current stock price. If not, one would effectively capture an option premium equivalent to the forecast dividend amount. 

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