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If you’re tired of following stock tips or the charts that your software package throws up on your screen – only to be burned by the stockmarket volatility – you might be interested in a ‘mechanical’ investment strategy.

A mechanical strategy is where you select a valuation criterion (or criteria) and simply buy the stocks that fit the bill. It could be the stocks with the lowest price/earnings (P/E) ratios, the highest dividend yields or the lowest price-to-NTA (net tangible assets) ratios.

The most famous mechanical strategy is the Dow Dividend – or “Dogs of the Dow” – approach in the USA. The idea of the Dogs of the Dow is to buy blue-chip stocks after they have been beaten down in price. How you tell this is to look at the dividend yields – a high yield means that the price of the shares has fallen.

With this value-oriented strategy, you take a sample of the 30 stocks in the Dow Jones Industrial Average (DJIA), and buy equal amounts of the ten stocks that show the highest dividend yield (using the most recent dividend). After a year, when the top-yielding list is updated, you keep the ones that are still on the list and sell those that have fallen off.

A variant of the strategy is the “Pigs of the Dow”, in which at the end of the year, the investor buys the five worst-performed Dow stocks in terms of price decline that year. At the end of the following year, the Pigs are sold and that year’s five biggest losers are bought.

But it’s the Dogs approach that is most popular, and for good reason: it has done very well for its followers. From 1929 to 2003, the Dogs of the Dow strategy outperformed the stockmarket (the S&P 500 index) handily, returning about 14 per cent a year compared to the market return of 11.7 per cent a year during that time.

In 2006, the Dogs of the Dow returned 22 per cent, versus 16.3 per cent for the index. But in 2007, the Dogs of the Dow delivered a loss of 1.4 per cent, versus a 6.8 per cent rise for the Dow as a whole. Financial and consumer-related stocks hurt the Dogs’ performance in 2007.

With the help of Cyrus Shum of Morningstar Research, let’s have a look at how the strategy has worked in Australia, using the stocks of the S&P/ASX 50. Let’s call them – and this is not original – the “Dingoes of the ASX 50”.

At the end of 2003, the highest-yielding stocks in the S&P/ASX 50 were:

Company Yield

CSR

10.63%

Westfield America Trust

8.66%

Bluescope Steel

7.80%

General Property Trust

7.09%

Westfield Trust

6.92%

Mirvac Group

6.53%

Stockland

6.41%

Tabcorp

6.22%

Telstra

6.14%

Macquarie Bank

5.79%

Assume we bought $1000 worth of each. At the end of 2004, our portfolio had risen by 28.94%, versus 20.83% for the S&P/ASX 50. The strategy worked.

On 31 December 2004, we crunched a new list of the ten highest-yielding stocks in the S&P/ASX 50. They were:

Company Yield

Mirvac Group

7.49%

Stockland

7.14%

National Australia Bank

6.15%

Bluescope Steel

5.93%

General Property Trust

5.88%

CSR

5.67%

Commonwealth Bank

5.62%

St George Bank

5.58%

ANZ Bank

5.31%

Telstra

5.17%

We sold those that had dropped out of the list, and bought the new entrants.

At the end of 2005, our portfolio had gained 8.74 per cent in value. But the S&P/ASX 50 had risen by 17.4 per cent. The strategy did not work.

Again, we altered the portfolio. The ten highest-yielding stocks in the S&P/ASX 50 at the end of 2005 were:

Company Yield

Mirvac Group

9.47%

Suncorp-Metway

8.06%

Telecom New Zealand

8.06%

Telstra

7.91%

Bluescope Steel

7.53%

Stockland

7.05%

AGL

6.54%

Macquarie Airports

6.31%

General Property Trust

5.95%

Qantas

5.93%

This group – our 2006 portfolio – performed well, adding 16.4 per cent. Unfortunately, the S&P/ASX 50 recorded a 17.8 per cent gain.

Undaunted, we prepared a new list on 31 December 2006. The candidate Dingoes were:

Company Yield

Telecom New Zealand

12.01%

Telstra

9.24%

Zinifex

7.98%

IAG

7.85%

Qantas

7.43%

Transurban

7.19%

Mirvac Group

7.13%

Macquarie Airports

6.94%

Macquarie Infrastructure

6.25%

Wesfarmers

6.09%

Oh, oh – by the end of 2007, the strategy was really in the doghouse: our portfolio lost 6.7 per cent, compared to the S&P/ASX 50’s rise of 11.7 per cent.

Cumulatively, in the three years that our exercise has covered, the Dingoes have returned 11.1 per cent a year – well behind the index’s return of 16.9 per cent.

Does this mean that the Dingoes are Duds?

Not really.

Firstly, three years is a short time over which to back-test a mechanical strategy. Secondly, the fact that the Dogs/Dingoes strategy is based on dividend yields means that it is biased against resources companies, which are usually not big dividend payers, preferring to reinvest profits in ongoing exploration or mine/oilfield stgelopment activities.

And in recent years, this bias has worked against the Dogs/Dingoes strategy – big-time. The major driver of the bull run over recent years has been the China/India demand for commodities: our big miners have been powering the stockmarket. For example, a look at attributional analysis of the S&P/ASX 200 Index in 2007 (by Souls Funds Management) shows that BHP Billiton alone was responsible for more than one-third of the index’s rise in 2007. BHP’s takeover target, Rio Tinto, accounted for about 11 per cent of the rise.

But with dividend yields of less than 2 per cent, BHP and Rio are never going to make it into the Dingoes list.

According to Souls, just five stocks – BHP Billiton, Rio Tinto, Commonwealth Bank, Woolworths and CSL – accounted for more than three-quarters of the S&P/ASX 200’s 12 per cent rise last year. In a smaller index like the S&P/ASX 50, the hefty contribution of these heavyweights is magnified even further, And of these, only CBA is a likely Dingoes candidate in any given year: CSL also has a yield below 2 per cent – it too reinvests heavily in R&D – while Woolworths’ yield is a princely 2.5 per cent.

In short, the Dingoes strategy does not pick up the central theme that has been powering the stockmarket in recent years. (The sixth-biggest contributor to the S&P/ASX 200 index last year, Fortescue Metals, doesn’t even make a profit, let alone pay a dividend!) Over the longer-term, this could be expected to even out.

If you want an easy-to-follow, low-maintenance, low-transaction-costs strategy that only takes a few minutes to change, once a year – and which will turn out to be pretty tax-effective – you could try the Dingoes of the S&P/ASX 50, and trust that over the longer-term, it will have similar success to the Dogs of the Dow.

If so, here is the updated list of the Dingoes, as at the end of 2007:

Company Yield

Telecom New Zealand

7.68%

Zinifex

7.44%

Transurban

6.74%

Telstra

6.10%

Mirvac Group

5.60%

Macquarie Infrastructure

5.56%

Tabcorp

5.48%

Stockland

5.44%

Qantas

5.36%

Suncorp-Metway

5.30%