The Dow Dividend Strategy An Interview with John Downes

Has your portfolio fared well with the recent stock market correction? Do you understand the fundamentals of the Dow Dividend Strategy? In this exclusive interview, Dr. Terry Zickerman discusses The Dow Dividend Strategy with author John Downes.

Zickerman: The modern application of the Dow Dividend theory goes back to the 1973 Bear market. Please discuss the theory, the market and the economic conditions at that time.

Downes: The year, 1973 saw the beginning of a two-year economic recession­­ precipitated by the Arab oil embargo and accompanied by high inflation led by oil prices, bank failures and the worst Bear market since the Great Depression. Not unlike today, the market in 1973 was led by a relative handful of blue-chip growth stocks known then as the “Nifty Fifty,” that institutions had bid up to multiples far in excess of sustainable corporate growth rates. When the Bear market settled in, 27 of the Nifty Fifty dropped an average of 84% from their 1971-1972 highs.

The year, 1973 also happened to be the year that Michael O’Higgins, then an institutional stockbroker, began his career as a money manager. His discovery and application of a strategy based on high-yielding Dow industrial stocks was the basis of the book we co-authored, Beating the Dow, which was published in 1990. Beating the Dow popularized the strategies now widely-known as the “Dow Dividend Theory” or, as Barron’s dubbed it, the “Dogs of the Dow.”

The theory is based on the premise that components of the Dow Jones Industrial Average­­household names such as General Electric and Exxon are among the most widely-held, widely-analyzed, widely-publicized and economically important companies in the world; and they have more resilience than risk. Being run by human beings, they have problems from time-to-time and when they do, the market hammers them like any other stocks. Unlike most other stocks, however, these have the financial and human resources that, combined with the pressure of shareholders, enables them to address their problems and adapt to changing conditions.

By purchasing the ten highest yielding Dow stocks­­those whose prices are lowest relative to their dividends­­you are automatically buying them cheap. By holding them for a year, then selling only those that are no longer the highest-yielding, you are automatically selling them dear. You get not only the capital gain, but the dividend income as well.

Over the 25-year period from 1973 through 1997, a strategy of buying the ten highest-yielders in equal dollar amounts and holding them for a year, then repeating the same exercise, has produced an average annual total return of 18.3%. That compares with a total return of 11.2% for the other 20 stocks and 13.0% for the overall Dow.

A variation we call the “Flying Five,” screens the five highest-yielders for those with the lowest dollar prices. Lower-priced shares move in greater percentage increments than higher-priced shares. This strategy, sacrificing some diversification, produced a total return of 21.1% versus 11.8% for the other 25 and 13.0% for the Dow over the same 25-year period.

It’s important to note that the period from 1973 to present has tested the strategies under every imaginable modern market condition. In the 1973-74 Bear market, the Dow declined 45%; however, the Beating the Dow strategies made money.

Zickerman: When I spoke with you last year, you were correct in stating, “…Inflation being so well controlled and if anything, long term rates should come down.” What is your opinion of the economy and the market today?

Downes: Inflation remains low and the economy remains fundamentally strong. Despite the market rally in the third quarter, spurred by the Fed [Federal Reserve] rate cuts, corporate earnings clearly showed a loss of momentum, however, that you need to sustain a Bull market. We’ll probably see further rate cuts and some mild deflation, both of which are good for stocks. But the Dow Jones and S&P 500 [Standard and Poor’s 500] averages, which have been been inflated by today’s equivalent of the old Nifty Fifty, will come down to levels closer to the historical market P/E [price/earnings] as those overvalued market leaders begin turning in disappointing earnings (as Coca-Cola, for one example, already has). Since the market’s underpinnings will still be relatively strong, we’ll see a rotation into high-capitalization value stocks, exactly like those selected by the Dow Dividend Theory.

Zickerman: There are many mutual funds­­approximately nine thousand seven hundred and ninety three. The majority of funds have not outperformed the indexes. Can you comment?

Downes: In an institution-dominated market, the funds are the averages, so this will always be true. Any system that can outperform the indexes will automatically outperform most funds.

Zickerman: John, a series of articles in Barron’s discuss the Dow Strategies quarterly. Because you are an authority, Barron’s quotes you concerning performance. What has been the performance over the past several months compared to the major indexes?

Downes: As I suggested in answer to your first question, our strategies do best in down and sideways markets and well, but not quite as well in momentum-driven, raging Bull markets. There are several reasons for this: A momentum market sends high-priced stocks higher­­overvalued becomes more overvalued, while undervalued stocks, like ours, tend to be put on hold or rise at slower rates.

Also, the Dow is a price-weighted average, which means higher priced stocks have more influence on the average itself than lower-priced shares. Our stocks are lower-priced, so we get a double whammy in the sense that our stocks may gain­­even gain spectacularly, but the Dow, and the S&P (which is indirectly price-weighted) gain more. For the last three full years, 1995 through 1997, our high-yield ten portfolio averaged a total return of 28.8%, which slightly lagged the Dow’s total return of 30.1%.

Now take the 1998 market, which started disintegrating in mid-summer. By the end of the third quarter, the year-to-date Dow total return was 0.5%. Our five-stock portfolio’s (Flying Five) total return was 6.4% and the ten-stock portfolio, 2.7%. “Flea-bitten no more, Dow Dogs are barking up the right tree again,” reported Barron’s. When the Fed cut rates and the market took off again in October, the Dow’s ten-month gain jumped to 10.1% while our five and ten-stock portfolios rose to 11.9% and 7.6% respectively. Our stocks gained, but the Dow gained more.

Zickerman: After studying the performance of the Dow Dividend Strategies over the last 25 years, what inferences can you make about returns in the strategies versus the market?

Downes: With an average annual return of over 20% for more than 25 years, versus 13% for the Dow, I would say our strategies have performed incredibly well. Especially with a choppy market in the forecast, we expect our outperformance to continue. History has shown-from 1973-74 right up to August-September, 1998-there is downside protection in high-yielding Dow stocks.