With the new year just around the corner, it's time to dust off the Dogs of the Dow theory again. For those of you not familiar with the premise, it's pretty simple. Of the thirty stocks that make up the Dow Jones Industrial Average, the 'dogs' are the ten stocks in the Dow that are considered to be the most undervalued. The theory is that those ten most undervalued stocks (the 'dogs') at the end of one year are poised to beat the Dow Average the following year. Does it work? Surprisingly, it does work more often than not. Let's take a look.

How do we determine just how undervalued a stock may be? In this particular case, we look at the dividend yield. While it's not necessarily the perfect measure of value for a stock, it is generally a good indication of how a stock compares to another. This is especially true for old blue-chip stocks like the ones you find in the Dow, where dividends are a little more common. To find your undervalued dogs, simply find the ten Dow stocks with the highest dividend yields. 

But does this really work? There are always exceptions, but the idea does have some statistical merit. In five of the last eight years (including 2003 so far), the ten highest yielding stocks did indeed do better than the overall Dow average. This didn't mean that the ten dogs didn't lose money in some years, such as 2001 and 2002. But even in those years, you still would have been better off with the dogs. In fact, even though 2004 is probably going to be one of those years that the theory doesn't work (barring a miracle today and Friday), we still like the idea of relatively low priced stocks. And statistically, the numbers support the theory. Since the early 70's, the average annual return on this theory would have been 17.7%. That's significantly better than the Dow's average annual gain of 10.9%. Take a look at last year's dogs and how they fared against the Dow, even though Merck and GM threw a wrench in the works. (Note that some of these Dow stocks were actually taken out of the index in the middle of 2004.)

Dogs of the Dow - 2004


So what about 2005? Take a look below for your likely 2005 "Dog" candidates. It's neither logical nor scientific, but it is food for thought. If the theory holds up, these stocks will have outperformed the Dow Average when we check in again at the end of 2005.