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Could the ‘Dogs of the Footsie’ outperform in 2018?

A mechanical investment strategy, Dogs of the Dow, was popularised by the 1991 book Beating the Dow by Michael B. O’Higgins. The strategy uses dividend yield as an indicator of value and is very simple: buy the 10 highest yielding stocks of the Dow Jones index at the start of the year and sell them at the end.

The strategy and versions of it have been applied to other stock indexes, including the FTSE 100. Money Observer claims its Dogs of the Footsie is “well ahead over the past 15 years, growing by an average annual 12.2% in total return terms, two-and-a-half times the 4.8% total return figure for the FTSE 100 index.”

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Now, I’m not a great fan of mechanical investing strategies — too many of them stop working after a while — but the Dogs are always worth a look as a source of potential big winners.

The current 10 in the doghouse

The table below shows the 10 FTSE 100 stocks with the highest dividend yields at the time I’m writing.

  Recent share price (p) Forecast yield (%)
Centrica 138 8.6
Direct Line 371 8.1
Next (LSE: NXT) 4,415 7.9
SSE (LSE: SSE) 1,301 7.2
Taylor Wimpey 205 6.7
Barratt Developments 642 6.7
GlaxoSmithKline 1,320 6.2
Lloyds 67 6.2
Marks & Spencer 313 6.1
BP 520 5.9

Source: Digital Look

Highest-yielder Centrica, the owner of British Gas, is about to chalk-up three years of earnings declines but, as my Foolish colleague Harvey Jones has discussed, it could be set for a brighter outlook in 2018. The other stock yielding in excess of 8%, insurer Direct Line, also has its fans, with fellow Fool Peter Stephens having written about both its income prospects and capital growth potential.

However, the two stocks in the 7% yield bracket — namely, Next and SSE — look particularly attractive to my eye.

Overly negative

Online shopping habits have been disrupting the high street and I have to confess I’m not wildly enthusiastic about most retailers with large bricks-and-mortar estates. However, Next has a long history as an expertly managed business, with superior margins and cash flow, and superb shareholder returns. I believe investors have become overly negative on the company’s future, as evidenced not only by the giant dividend yield, but also by a depressed price-to-earnings (P/E) ratio of 10.9.

There’s no denying that conditions are challenging for Next’s stores but its directory (online) business continues to show good growth. WH Smith is an example of a retailer with one weaker arm and one stronger arm that’s still delivering for its shareholders and I believe Next can do the same. As such, I rate the stock a ‘buy’.

Scope for a re-rating

Investor appetite for utility SSE has been sapped by a pending retail price cap and fears of more extensive political intervention in the UK energy sector. However, the company has a history of adapting well to changing external circumstances, which has helped it to build one of the longest records of annual dividend increases among the members of the FTSE 100.

I reckon the market is underestimating the company’s ability to adapt and is overly fearful of political risk. SSE’s high yield and a P/E of 11.2 mean there’s considerable scope for a re-rating of the shares, if — or, as I believe, when — market sentiment towards the business improves. Again, this is a stock that looks very buyable to me at its current level.

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G A Chester has no position in any of the shares mentioned. The Motley Fool UK has recommended WH Smith. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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