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Car bites dogs
hunting for dividend income

I like to begin each year by hunting for dividend income with the Dogs of the Dow and the Dogs of the TSX. Both versions of the time-honored Dogs strategy start from the simple premise that blue-chip stocks are too big to fail. The theory goes that if you can buy these stocks when they're in the doghouse and temporarily cheap, you can benefit from their juicy dividend yields and maybe even cash in on some capital gains as their share price recovers.

In the classic Dogs of the Dow method, invented by stockbroker Michael O'Higgins, you pick the 10 stocks in the Dow Jones Industrial Average with the highest dividend yields. In most cases, these stocks are paying high yields because they're perceived as slow-growing or troubled firms dogs in other words. You hold them a year, collect their lush dividends, then replace them with a new pack of dogs. In a good year, many of these giant U.S. stocks not only wind up paying you a nice yield, but go up in price as growth picks up or problems fade away. Similarly, in the Canadian version you select the 10 stocks in the S&P/TSX 60 index with the highest dividend yields and give them a year to hunt before returning them to the pound.

How have these strategies done over the long haul? Quite well, thank you. The Dogs of the Dow have produced average annual gains of 14.6% since 1973, or 3.4 percentage points better than the Dow itself. North of the border, the TSX Dogs have also performed admirably. David Stanley, University of Guelph professor emeritus, tracks the Canadian dogs and rebalances his portfolio each year on May 25. He calculates that those dogs have gained an average of 13.5% a year since 1987, trouncing the index by 3.6 percentage points a year.

Unfortunately, last year's Dogs of the Dow didn't live up to expectations. They finished 2005 with a whimper and a 5.1% loss hardly an inspiring result given that the Dow itself returned 1.7%. The best-performing dog in the pack was Altria, the cigarette-maker formerly known as Philip Morris. The stock (which I own in my personal account) gained 27.7%. However, its gains weren't enough to offset the stunning smash-up of General Motors, another of the Dogs of the Dow. It lost 48.4%.

The GM debacle points out the problems of buying companies simply because they happen to be cheap. This Dog of the Dow proved to be truly a dog. In fact, the automaker was the only company in the Dow to lose money for investors last year, costing them $6.91 (U.S.) per share. It carries so much debt that Standard & Poor's cut its debt rating to a B, which is well below investment grade and deep into junk territory. It doesn't help that GM's pension and healthcare costs are marching relentlessly higher, a legacy of generous wage settlements in the past.

Buying GM today is in many ways like buying a lottery ticket. Should the company manage to avoid bankruptcy, its extraordinarily low price could make it quite a deal. On the other hand, GM is one case where the theory that blue chips are too big to fail might be put to the test. Should the company go bust, GM shareholders would probably lose everything they've invested.

Despite all those problems, GM still tops this year's dogs list, at least if you construct it according to the traditional criteria. The complete list (with yield) includes General Motors (10.3%), AT&T (5.4%), Verizon (5.4%), Merck (4.8%), Altria (4.3%), Pfizer (4.1%), Citigroup (3.6%), DuPont (3.5%), JP Morgan Chase (3.4%) and General Electric (2.9%).

What if you can't stomach the thought of buying a company as troubled as GM? Conservative investors who are more interested in safety than in yield might want to consider choosing Coca-Cola (2.7%) instead. The purveyor of bubbly beverages nearly made it onto this year's list, but it was just edged out by General Electric's fractionally higher dividend yield.

North of the border, the Canadian dogs performed much better in 2005 than their U.S. counterparts, and sped to a gain of 22.9%. The northern dogs narrowly failed to keep up with the S&P/TSX60, which was powered ahead by the super-strong performance of energy stocks, but I think a 22.9% gain should still be enough to satisfy just about any investor.

No doubt to offset my good fortune with Altria, I also happened to own BCE, the worst performing Canadian dog. Its healthy dividend just managed to push the phone company to a slight gain last year. In contrast, some of the other Canadian dogs did very well indeed. TransAlta gained 46%, and Royal Bank soared 45%. I warned readers last year that Bombardier's dividend was shaky and so it proved to be, but the reduced dividend didn't stop the stock rising 16.9% on the year.

This year the Canadian dogs are made up of (with yield) BCE (4.7%), Quebecor World (4.2%), TransAlta (3.9%), CIBC (3.6%), TransCanada (3.3%), National Bank (3.2%), Enbridge (3.2%), Bank of Nova Scotia (3.1%), Bank of Montreal (3.0%), and Royal Bank of Canada (2.8%).

Let me sound a note of caution about some of these Canadian dogs. In past years, TransCanada occupied a prominent spot near the top of the list of high yielders. Its new position in the middle of the pack has me concerned that it has perhaps gotten a little ahead of itself. I'm also worried that the banks have had a good run lately and investors might be forgetting that they can, and do, occasionally decline.

As always, it's vital to fully research each stock before investing. After all, you don't want to load up your GM Sierra with a pack of dogs only to stall on the way to the bank.

From the February/March 2006 issue.

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