A Brief Primer
Trading the Dogs of the Dow system is fairly simple and straight forward. At the start of the year, you take a look of the list of Dow 30 Industrial companies (DJIA), choose the 10 carrying the highest dividend yields and then divide your money equally among those 10. A year later, the process gets repeated, spreading your funds among the new list of top-10 candidates.

The basic premise is that these are all high-quality companies, and, for whatever reason, a few have temporarily fallen out of favor (hence the high yield), but will likely bounce back. (For a more detailed background on this system, see Dogs of the Dow, A conservative, Low Maintenance Strategy That Occasionally Has Its Day.) From 2007 through 2009, the Dogs underperformed the DJIA. However, they had a strong turnaround last year, gaining 20.5%, versus 14.1% for the Dow itself.

This Year’s Models
At the end of 2010, these were the Dow components with the highest yields (in descending order): AT&T (T - Free AT&T Stock Report), Verizon (VZ - Free Verizon Stock Report), Pfizer (PFE - Free Pfizer Stock Report), Merck (MRK - Free Merck Stock Report), Kraft Foods (KFT - Free Kraft Stock Report), Johnson & Johnson (JNJ - Free J&J Stock Report), Intel (INTC - Free Intel Stock Report), DuPont (DD -Free DuPont Stock Report), McDonald’s (MCD - Free McDonald's Stock Report), and Chevron (CVX - Free Chevron Stock Report). The yields ranged from a high of 5.85% for AT&T, down to 3.16% for Chevron.

First Quarter Scorecard: Dividends Make A Difference
The March period had several strong performers among the Dogs, including a 17.8% increase for Chevron shares, 16% for Pfizer, and a 10.2% advance for DuPont.  However, these were offset by an 8.4% decline for Merck, while Johnson & Johnson and Intel both fell about 4%.

Overall, based on price movement alone, the Dogs underperformed in the first quarter. If you had started out with an equal dollar weighting in all the Dow Jones 30 stocks, you were up 4.8% in the period. The Dogs, meanwhile, were a full 100 basis points behind, with a return of 3.8%. 

However, dividends play a key factor in this strategy, especially since we pick the highest-yielding vehicles at the start of the year. Factoring in the dividends that were paid out, the Dow 30 generated a return of 5.8%, or 100 basis points better than without dividends. Put another way, dividends accounted for 17% of the Dow’s performance.

For the Dogs, however, the difference is even greater. Adding back in the dividends earned, the return was 5.4%, a full 160-basis-points higher than without. In this case, dividends accounted for nearly 30% of an investor’s potential return.

Six Weeks Later, The Dogs Take The Lead
One of the key advantages of focusing on the highest yielding Dow companies is that you have that extra payout working in your favor. It doesn’t always offset other factors that can weigh on a stock’s performance, but it often helps.

Here's a case in point. Examine the results of our comparison six weeks later. The Dow 30 Industrials as a group have since picked up a little more ground, advancing 6.9% for the year through May 13th. Adding back the dividends, we again show a 100-basis-point improvement, with a total return of 7.9%. The Dogs meanwhile, have taken the edge, rising 8.7% on price alone, and an impressive 10.3% with dividends added back in.

A good part of the outperformance was fueled by the fact that the Dogs all advanced in the period, with half showing double-digit percentage gains. A fully weighted position in the Dow, meanwhile, was largely weighed down by negative returns from Cisco (CSCO - Free Cisco Stock Report, down 16.3%), Bank of America (BAC - Free Bank of America Stock Report, -10.5%), and Microsoft (MSFT - Free Microsoft Stock Report, -9.8%), as well as the smaller contribution from dividends.

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.