How To Beat The S&P 500 Index
March 14, 2016

How To Beat The S&P 500 Index

Twenty-five years ago, Michael O’Higgins showed the world how to beat the market. His 1990 international bestseller, Beating the Dow, explained a simple strategy that anyone could follow. It took ten minutes a year. Investors with the discipline to follow O’Higgins’ method since his book’s publication would have made a small fortune.

From 1991 until 2016, his strategy gained an average compound return of 12.76 percent per year. In a tax deferred account (not including transaction costs) it would have turned $10,000 into $201,315. Investors in Vanguard’s S&P 500 Index (VFINX) would have averaged a compound annual return of 9.7 percent per year. The same $10,000 would have grown to $101,265.

O’Higgins’ outsized returns were as unusual as his upbringing. His father worked for a variety of oil companies. His family lived in Venezuela, the U.S., Singapore, Nigeria, Libya, Indonesia and Italy. The future money manager was a reluctant academic. His father once yanked him out Singapore American School. “My grades were horrible,” said O’Higgins, “ I was having a great time. But I wasn’t doing any work so my dad pulled me out.”

After getting on track, he earned a B.Sc. in economics. O’Higgins worked at a couple of investment firms before he opened his own money management firm in 1978. He immediately began looking for a reliable investment method. “When everyone is placing their bets on the hare, maybe the safer, surer bet is on the tortoise,” he says.

In Beating the Dow, he wrote that buying the most unpopular stocks among the Dow Jones Industrials makes plenty of sense. Because of their pedigree, he says the index’s pariahs have a high chance of recovering. Dow companies have huge infrastructures, long histories, extensive customer bases and big revenue streams. “If the problem is poor management,” he says, “new management comes in, sweeps away past policies, makes strategic changes that adjust to new realities, kicks the horse’s flank to get it moving and starts making money again.”

He backtested two methods. One of his methods called for buying the Dow’s 10 highest dividend yielding stocks. He called this strategy, Dogs of the Dow 10 (DOTD 10). The second method­­–which had an even better backtested record–called for buying the 5 lowest priced stocks among the top 10 yielders. He called this method Dogs of the Dow 5 (DOTD 5). Steady or growing dividends are a sign of financial strength. O’Higgins said investors should buy these stocks and hold them for a year. After 12 months, investors would need to see if the same stocks still met the standard. Those that didn’t would get sold and replaced by those that did.

This year’s Dogs of the Dow 5 include Pfizer (PFE), Cisco Systems (CSCO), Verizon Communications (VZ), Merck (MRK) and Wal-Mart (WMT). As of March 3, 2016, their dividend yields were 4.01 percent, 3.87 percent, 4.36 percent, 3.53 percent and 3.02 percent respectively. This year, the dogs are already running. So far, the Dogs of the Dow 5 are up 2.69 percent. The Dogs of the Dow 10 are up 3.7 percent. By comparison, the S&P 500 was down 2.06 percent.

Both strategies have trounced the S&P 500 since Beating the Dow was published. But the Dogs of the Dow 5 (much as they did in the up to 1990 backtested study) beat the Dogs of the Dow 10. Not including taxes and transaction costs, the Dogs of the Dow 5 beat Vanguard’s S&P 500 over the past one, three, five, ten, fifteen, twenty and twenty five year periods.

S&P 500 vs. Dogs of the Dow 5
Average Annual Compound Returns To January 1, 2016

1 Year Return 3 Year Return 5 Year Return 10 Year Return 15 Year Return 20 Year Return 25 Year Return 43 Year Return
Vanguard S&P 500 Index (VFINX) 1.24% 14.8% 12.4% 7.2% 4.8% 8.08% 9.7% 10.09%
Dogs of the Dow 5 10.34% 21.2% 18.9% 9.8% 7.5% 8.7% 12.76% *14.98%

But if you’re looking for a strategy to beat the market every year (or even every five years) you’re not likely going to find it. Vanguard’s S&P 500 beat the Dogs of the Dow 5 in two of the 5 year periods between January 1991 and December 31, 2015.

Five Year Returns
January 1, 1991 – December 31, 2015

1991-1995 1996-2000 2001-2005 2006-2010 2011-2015
Vanguard S&P 500 Index (VFINX) 16.4% 18.3% 0.4% 2.2% 12.4%
Dogs of the Dow 5 30.2% 12.4% 3.2% 1.3% 18.9%

Will the Dogs of the Dow beat the market over the next 20 years? I think so. But it doesn’t mean that you or I will have the strength to keep them in our portfolios. If the market turns into a greyhound, the high dividend dogs are going to look slow.

Imagine this. In January 1995, your friend invests $10,000 in Vanguard’s S&P 500. He turns $10,000 into $35,027 after just five years, averaging a compound annual return of 28.5 percent. That’s how much the index gained between 1995 and 2000. Those were greyhound years.

Over the same time period, you invest $10,000 in the Dogs of the Dow 5. It turns $10,000 into $21,094. That’s a compound annual return of 16.1 percent. The index trounced the dogs.

Greyhound Markets Beat Dividend Dogs
January 1995- December 31 2000

Average Annual Return $10,000 Invested Turned Into
Vanguard S&P 500 (VFINX) 28.5% $35,027
Dogs of the Dow 5 16.1% $21,094

The S&P 500 Beats the Dow 5 (DOTD 5) For A Decade

Average Annual Return $10,000 Invested Turned Into
Vanguard S&P 500 (VFINX) 12% $31,048
Dogs of the Dow 5 10.6% $27,425

The dogs didn’t catch up until 2006. That year, they gained a whopping 40 percent. The S&P 500 gained 15.79 percent
Could you doggedly stick to a plan that might underperform for a decade? If so, you might be able to collar the Dogs of the Dow. History is in your corner. The strategy makes sense. But at times, it will test a level of patience that few investors have.

Andrew's $4,512 Car
O’Higgins Asset Management/Bloomberg

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This article contains the opinions of the author but not necessarily the opinions of AssetBuilder Inc. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is distributed for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.

Performance data shown represents past performance. Past performance is no guarantee of future results and current performance may be higher or lower than the performance shown.

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