Underdogs of the Dow

06/03/2005 12:00 am EST

Focus:

Charles Carlson

Editor, DRIP Investor

With a history dating back to 1946, Dow Theory Forecasts is one of the most well-known and prestigious services available. Here, editor Charles Carlson discusses his popular contrarian theorythe Dow Underdogswhich has consistently outperformed the Dow.

"Our Dow Theory model currently says that the market’s primary trendthe trend that will last for 18 to 24 monthsis bullish. The correction that we had since March was traditional pullback within an ongoing bull market. I know it’s caused a lot of people consternation that’s the purpose of pullbacks. They restore the wall of worry. This one has been worrisome against a backdrop of high energy prices, an uptick in interest rates, inflationary expectations, and so forth. But again, Dow Theory says this is a correction within a bull market.

"One investment style that I think makes a lot of sense for a portion of your investment dollars in today’s choppy market is contrarian investing. It’s hard to buy stocks that have been ‘creamed’ because you think they will get worse. However, if you truly are going to buy low and sell high, it makes sense that you will have to buy stocks that are down for a reason. Thus, I would like to share a contrarian strategy that is very easy to follow and has worked over the last 75 years, over the last 50 years, 30 years, 20, ten, and each of the last five years, and it’s beaten the Dow over every one of those time periods.

"We’ve looked at Dow stocks for many, many years and I was a manager of a mutual fund that was devoted exclusively to Dow stocks. We’ve done a ton of work on the Dow over the years. One thing I started to see over the years, was that the worst performers in one year tended to do very well the next. If you go back to 1999, the worst performing stock in the Dow was Phillip Morris, down more than 50%. The next year it was the best performing, up 106%. And what is even more impressive is that 2000 was a down year for the Dow. In 2000 and 2001 it was the same story, just different stocks. In 2000, the two worst performing stocks in the Dow were Microsoft and Intel, with both declining over 60%. In 2001, they were among the best performers.

"This strategy works particularly well with Dow stocks. If you were betting on beaten down stocks, you would want stocks that are going to be around in the future. You will want stocks that don’t go bankrupt and this doesn’t happen too often in the Dow. Those stocks generally have the financial wherewithal to survive. Indeed, 21 of the 30 stocks in the Dow today can date their roots back over 100 years. The youngest company in the Dow right now is Home Depot, which has been around for 25 years. So these are companies that have stood the test of time and have demonstrated the ability to survive over time.

"The other thing that I like about Dow stocks involves reversion to the mean, which basically says that in the short run things can move to extremes but over the long term, they follow a ‘golden mean’, a long-term average. So when you see Dow stocks move to extreme levels, either to the upside or the downside, mean reversion suggests that at some point over time they will revert to their long-term averages. And that’s what we bet on with this strategy. It forces you to go in and buy stocks in the Dow that have moved to extremes on the downside in hopes, historically speaking, that they will come back. Importantly, I’m not suggesting that you go out and buy just one stock, but rather a group of five or ten.

"I would point out that this sounds familiar to a strategy known as the Dogs of the Dow, which suggests buying the ten highest yielding stocks in the Dow each year. But that is not a contrarian strategy, as the stocks with the highest yield typically don’t change from year to year. Thus, stocks like GM and Citigroup will always be included in the Dogs of the Dow strategy, but companies like Intel and Microsoft will not.

"I focus on this strategy at the start of every year, but investors could start this strategy on any day by buying the worst performing Dow stocks over the latest 12-month period and holding them for 12 months (plus one day, so that you get long-term capital gains). We update this information everyday on our Web site for free, letting you know what the worst performers were over the most recent 12-month period. (Investors can check the latest list of Underdogs at www.dowunderdogs.com). Here are the latest ‘underdogs’:

Merck (MRK NYSE)
General Motors (GM NYSE)
American International Group (AIG NYSE)
Pfizer (PFE NYSE)
Wal-Mart (WMT NYSE)
IBM (IBM NYSE)
Alcoa (AA NYSE)
Coca-Cola (KO NYSE)
3M (MMM NYSE)
Intel (INTC NASDAQ)

"I’d also note that this theory works on the downside as well as the upside. Due to the concept of reversion to the mean, stocks that go to extreme on the upside will also likely revert to the mean. And that has been the case in many years. In 2002, the best performing Dow stock was Kodak. It was the worst performer in 2003. The best performing stock in 2003 was Intel, which was the worst performer in 2002. Therefore, there are investors who like to play the long and the short side of the market with this strategy. To play both ends, you would buy a basket of stocks that have been the worst performers in the Dow and leverage that by going short a basket of stocks that were the best performing during that same year. And if you’re uncomfortable shorting stocks, you can do the same thing by using LEAPs, which are long term options on stocks. Instead of buying the shares, buy the call LEAPs and the put LEAPs."

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