Putting the Dogs of the TSX through their paces

Sometimes, dogs do indeed have their day.

In fact, the Dogs of the Dow have had quite a few good days. From 1957 to 2003, the investment strategy returned about 14.3 per cent a year, easily outpacing the 11-per-cent annualized gain on the Dow Jones industrial average. After lagging the Dow from 2004-09, the strategy bounced back last year, returning more than 20 per cent.

If you're not familiar with the Dogs approach, the most common variation involves buying the 10 stocks in the Dow Jones industrial average that have the highest dividend yields, then updating the portfolio once a year.

There's logic behind this strategy. The dividend yield is essentially a way to assess the attractiveness of a stock. A high yield is often a sign that a stock is unloved (thus the Dogs moniker) and must offer a larger payout to attract investors. Unloved stocks can frequently be good value buys, and several studies have shown that, over time, value stocks tend to outperform the broader market.

That means the Dogs strategy should translate well in other markets, including Canada's. So recently, I checked to see which 10 stocks are the Dogs of the S&P/TSX 60. I've listed them in the accompanying table. Their dividend yields range from 13.5 per cent to 4.3 per cent.

Those are all very attractive payouts, but I wouldn't run out and buy up all of these stocks just yet. That's because, for all of its long-term success, the Dogs theory has some serious limitations - namely, its reliance on a single variable. Throughout my years of researching history's best investment strategies, I've found that the most successful approaches always examine more than one variable; usually, they look at four, five, six, or more. It makes sense - looking at one variable doesn't give you anything like a comprehensive picture of a company.

It's Cheap For A Reason

For example, TransAlta comes in third on the Dogs list, with an impressive 5.71-per-cent yield. Essentially, that figure is saying, "This stock is dirt cheap," as it trades for a very low price considering its dividend payout.

Sometimes, however, a cheap stock is cheap for good reason. And that appears to be the case with TransAlta. Its earnings per share have declined five times in the past seven years. It has nearly $4-billion in debt, annual earnings of only about $218-million, and it has averaged just an 8.4-per-cent return on equity over the past decade. Not exactly the value play it appeared to be, is it?

My research supports an approach that looks much deeper into a Dog's financials and fundamentals before buying its shares. With that in mind, I thought I'd see which of the TSX Dogs get approval from my "Guru Strategies," each of which is based on the approach of a different investing great. Here are three that made the grade by passing a value-investing model based on the work of James O'Shaughnessy, a well-known money manager and author of What Works on Wall Street.

Shaw Communications Inc. This Calgary-based cable provider ($9-billion market capitalization) is a favourite of Mr. O'Shaughnessy's value approach. It stands out for a few reasons: its size (nearly $4-billion in trailing 12-month sales); its $3.18 in cash flow per share; and its 4.6-per-cent dividend yield.

Sun Life Financial Inc. This Toronto-based insurance and financial services firm gets strong interest from my O'Shaughnessy-based model, thanks in part to its 4.9-per-cent dividend yield. This approach looks for larger stocks with strong cash flows and high yields; Sun Life's $4.05 in cash flow per share (more than three times the market mean), $18-billion market cap, and that solid yield all make the grade.

TransCanada Also based in Calgary, TransCanada develops and operates natural gas and oil pipelines, power generation facilities, and gas storage facilities. It does have exposure to the nuclear industry (through its stake in Bruce Power), which could be affected by the events in Japan. But nearly 80 per cent of its generating capacity is from non-nuclear sources. My O'Shaughnessy-based value model sees the $28-billion-market-cap firm as a solid value play, thanks to its size, $4.82 in cash flow per share, and 4.3-per-cent dividend yield.

The Dogs of the Dow approach can tip you off to undervalued picks. But while it can be a good starting point, it's no silver bullet. Only by combining a Dogs approach with a system that digs deeper into a firm's financials and fundamentals can you find which Dog-type stocks are really worth a look and which are likely to be, well, just dogs.

A portfolio with bite

Not all of the 10 TSX Dogs stand up to closer inspection.

Source: Bloomberg

John Reese is CEO of Validea.com and Validea Capital, and portfolio manager for the Omega Consensus funds. Globe Investor has a joint venture with Validea.ca., a premium Canadian stock screen service.