Dogs of the Footsie 2014 trounces FTSE 100 with 13 per cent gain

Money Observer's Dogs of the Footsie, our portfolio of unloved stocks, has now been running for 15 years and is still going strong. Last year, it returned 7.3 per cent in share price terms, rising to 13.2 per cent when dividends are included, compared to 3.7 and 7.4 per cent respectively for the FTSE 100 index as a whole.

That was the fourth consecutive year in which the Dogs trounced the Footsie: indeed, the Dogs have led the way in 11 of the portfolio's 15 years of operation - rising to 12 years if we measure on total return rather than share price performance.

The three, five and 10-year statistics are impressive, as the table below (click to enlarge) shows, with the Dogs ahead over all three periods.

To find out which 10 FTSE 100 companies made the cut for this year's portfolio, read: Meet the Dogs of the Footsie 2015.

Buy at any time

The Dogs strategy is a simple one, based solely on the yield. It involves selecting the 10 highest-yielding constituents of the FTSE 100 index, putting an equal amount into each and holding them for a year.

Companies that have already announced they will cut their dividend are excluded - as has happened to J Sainsbury in the portfolio for 2015 - but market expectations of a cut are not enough to exclude them. You can get rankings of FTSE 100 constituents using the stock filter tool at our sister website Interactive Investor.

The beauty of the strategy is that it can be started at any time - you simply need the funds to invest and five minutes to use the screening tool - and does not need any technical knowledge or complicated analysis of cash flow, dividend cover or PEG (price/earnings-to-growth) ratios.

The strategy originated in the US with the Dogs of the Dow, which for a time was widely followed.

The US Dogs have, however, lost their form - perhaps because the Dow, with just 30 constituents, is a much narrower index; or perhaps because the constituents are changed only infrequently, when the committee decides that a company has 'an excellent reputation, demonstrates sustained growth and is of interest to a large number of investors', whereas FTSE 100 constituents are selected quarterly, based on their market capitalisation.

The underlying philosophy behind the Dogs strategy is that a high yield on a stock indicates a company that is out of favour with investors. When this happens, the share price will often fall further than is warranted by the fundamentals of the company's performance and, when that is recognised, the shares will bounce back sharply.

Share price bounce

That was the case for United Utilities and Imperial Tobacco in last year's portfolio, where fears of a dividend cut from the former and slowing growth from the latter were weighing heavily on their shares a year ago.

These were the two best-performing Dogs from last year's portfolio, with both reporting returns of more than 45 per cent in total return terms. Just half of the portfolio managed to beat the return on the FTSE 100 index, and four stocks actually lost money, even in total return terms.

But the good performances were more than enough to compensate for these laggards - underlining the benefits of investing in enough stocks to spread the risk.

Of course, a high yield can also be a sign that the dividend is unsustainable, and over the years many of the Dogs have cut their dividends during their time in the portfolio.

None of the 2014 constituents have actually cut - although Sainsbury's has warned that its final payment will be reduced - but cuts in previous portfolios have often actually led to a significant bounce in the share price, perhaps on relief that the cut is not as deep as expected or that the company is saving some of its cash.

A high yield can also indicate that the company is in financial trouble, but the Dogs' focus on the FTSE 100 means there is very little risk that any of them will go bust.

Dividend cuts

Dogs constituents can, however, be taken over: for instance Friends Life, which was called Resolution when the Dogs portfolio was assembled last year, is in the process of being acquired by Aviva, contributing to its good share-price performance over the year.

Dividends are not, of course, guaranteed: some of the most faithful income stocks have cut their payouts this year. Tesco led the way among food retailers as accounting irregularities added to the pressure of competition from discounters such as Aldi and Lidl; Sainsbury's will follow suit in the second half of this financial year.

Even utility companies, previous stalwarts of the Dogs portfolio and the income investor's go-to sector, have become less dependable.

Following the latest Ofwat determination, Severn Trent announced that it would cut its payout by 5 per cent from March 2016 - although the current year's dividend is safe - and that growth thereafter would be at least in line with the Retail Prices Index (RPI), well below the current pledge of RPI plus 3 per cent.

United Utilities is not warning of a reduction, but its growth rate will slow from the current RPI plus 2 per cent to simply RPI.

But Capita, which produces a quarterly Dividend Monitor, is not predicting significant further cuts. It expects the oil majors to manage to maintain their payouts, despite the fall in the oil price, and says that fall should be a positive for other parts of the stock market.

It expects growth in underlying dividends of 4.6 per cent in 2015, or 7 per cent after adjusting for the lower Tesco payout and the reduced payment from Vodafone following the sale of its US business. That is below the 21 per cent increase in 2014 - although most of that was due to special dividends - but it is still comfortably ahead of the rate of inflation.

US payouts at a low

Michael Clark, manager of Fidelity Moneybuilder Dividend, is also confident there will not be significant dividend cuts. He points out that the payout ratio of US companies, showing the proportion of earnings paid out as dividends, is still below its 30-year average.

And, while the yields on gilts and cash deposits have fallen and are now very low, the overall yield on UK equities has remained remarkably stable, despite fluctuations in profits, payouts and the level of share prices, and is attractive compared to other assets.

He favours sectors such as pharmaceuticals, telecoms - especially BT - and consumer goods companies, particularly as the economy recovers. But he remains unenthusiastic about banks.

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