Does it pay to buy the Footsie’s dividend dogs?

If there’s one thing we can be sure of when it comes to investing, its that a strategy doesn’t need to be complicated to work. Take the approach devised by US asset manager Michael O’Higgins in his book ‘Beating the Dow‘ — find the 10 highest yielding stocks on an index, invest equal amounts of money in each, leave your portfolio alone for a year and then repeat the exercise. 

According to O’Higgins, buying these dividend dogs would have returned 18% a year from 1973 to 1998, compared to ‘just’ 13% achieved by the Dow Jones index. Perhaps more importantly for UK investors, a similar strategy run by Money Observer using FTSE 100 shares would have returned just over 12% over the last 15 years. That’s a lot better than the 5% achieved by the index as a whole. 

So, if this strategy works, which shares would qualify currently as dividend dogs?

Top dogs

Given the recent volatility in the oil price and their refusal to cut payouts, it should come as no surprise that Royal Dutch Shell (7.14%) and BP (7.04%) head the list of the 10 largest yielding shares in the top tier.

After a particularly testing 2016, publisher Pearson (6.61%) also makes the cut, as do housebuilder Persimmon (6.45%), banking behemoth HSBC (6.38%) and utilities such as SSE (6.14%) and Centrica (5.89%).

Mobile operator Vodafone (6.22%), insurer Legal and General (5.86%) and outsourcer Capita (5.67%) complete the list.

Of course, you don’t necessarily need to pick 10 shares. A ‘small dog’ portfolio of 5 shares has been shown to perform even better, albeit with increased risk. The criteria for selecting these shares isn’t fixed either. Instead of identifying those with the highest yield, you could pick those with the lowest price to earning (P/E) ratios (ie, those companies whose shares look especially cheap relative to their forecast earnings).

What’s the catch?

Before you jump to invest in all or a sample of the aforementioned companies, however, it’s important to be aware of a few leash-like drawbacks and assumptions connected to this strategy.

Thanks to the commission fees involved, rebalancing a portfolio every year according to a set criteria is clearly more expensive than adopting a buy and hold-for-a-lot-longer mentality. Over time, this has the potential to really eat into your returns.

Secondly, it seems clear that this is a value-focused strategy built for patient investors. Those willing to select their holdings in this fashion must therefore be prepared to wait until confidence returns to the market or a specific company. Thanks to action bias — our very human tendency to want to do something rather than nothing — this isn’t always easy.

Third — and perhaps most importantly — the dividend dog approach assumes that large blue chips are able to weather turmoil better than most and refrain from cutting their bi-annual or quarterly payouts. While this may be the case most of the time, there are always exceptions. After all, no investment is ever risk-free. This shows why it may pay to reject companies where the dividend is looking increasingly unsustainable (revealed by the dividend cover ratio).

Despite these points, so long as you’re prepared to invest in a group of companies that may be experiencing tough times or are out of favour with the market (hence their very high yields), buying the dividend dogs could be the profitable strategy you’ve been looking for.

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Paul Summers has no position in any shares mentioned. The Motley Fool UK has recommended BP, Centrica, HSBC Holdings, and Royal Dutch Shell B. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.