DOGS OF THE NIFTY

Nifty as a benchmark

The importance of having a benchmark cannot be understated. Investing is a way of life and your benchmark is an investing lifeline. Its a road map showing you the way. One can also take a detour if and when it is necessary. It lets you know how your portfolio is performing and can help you to stay disciplined. Since having a benchmark is so important, the selection of one is critical. In the Indian context, most money managers use the CNX NIFTY as the benchmark for their portfolios. If your portfolio returns exceed those of the CNX NIFTY, you have out performance and vice versa. If any one is investing without a benchmark, the probability of getting lost is very high. Conversely if the benchmark is appropriately picked the chances of meeting your investment goals are higher. I find that many investors invest without a benchmark. This is too random a way of treating your hard-earned money. Most people don’t even realize this. For eg your portfolio may have earned 15 % but if the CNX NIFTY has moved 20 % you might have been happier with an ETF or index fund. Hence, this exercise of bench-marking is a ‘must do’. Your benchmark is your leash. If your portfolio deviates or more specifically under performs the benchmark consistently, you are unlikely to meet your investment objectives. (End of lesson!!). In terms of market capitalization the CNX NIFTY covers 67% of the listed stocks in the Indian stock universe. The CNX 500 represents 94 % of the listed stocks, so in terms of coverage the CNX 500 is actually a better benchmark than the CNX NIFTY. However, since the CNX NIFTY is actively traded, I have used it as the benchmark for this post.

Where are we on the Nifty?

The market has moved considerably in the current calendar year. The out performance in the small and mid cap segment is pronounced. The Nifty, in comparison, has moved from 6301.65 on 01st January, 2014 to 7790.45 on 25 th July, 2014 i.e. roughly 24 % till date. The following table shows the performance of the various indices (arranged from lowest to the highest) till date:

INDEX	01/01/14	25/07/14	%
CNX IT	9462.80	10339.70	9.27
CNX FMCG	17050.45	18741.80	9.92
CNX MEDIA	1795.20	2012.85	12.12
CNX PHARMA	7667.30	9168.15	19.57
CNX ENERGY	7931.70	9623.20	21.33
CNX NIFTY	6301.65	7790.45	23.63
CNX NIFTY JUNIOR	12987.05	16185.35	24.63
CNX 200	3162.90	3950.00	24.89
CNX 500	4921.25	6230.45	26.60
CNX REALTY	189.15	246.55	30.35
CNX AUTO	5292.65	6945.10	31.22
CNX MIDCAP	8114.00	10788.35	32.96
CNX METAL	2493.80	3335.40	33.75
CNX FINANCE	4737.60	6368.30	34.42
CNX BANK	11385.60	15322.25	34.58
CNX PSU BANK	2573.30	3552.00	38.03
CNX SMALL CAP	3461.60	5081.30	46.79

(Click on the Index to see the fact sheet)

This out performance by the small cap index is quite usual in the beginning of any bull run. There is bound to be a fair degree of consternation in the minds of investors when buying the small and mid cap stocks, since that they have moved considerably. However, there are opportunities in the stocks which form part of the Nifty composition. The advantage of buying stocks which form part of the Nifty is that even if one makes a mistake, or times it badly, you are definitely not stuck with a bad stock or a loser in your portfolio.

Dogs of the Dow strategy

A book published in 1991, titled ‘Beating the Dow’, by Michael O’Higgins and John Downes propounded a ‘Dogs’ strategy. The motive was to earn returns which are higher than those of the benchmark. The strategy calls for buying the ten highest yielding stocks in the Dow Jones industrial average at the start of each year. The assumption is that an equal amount of money is allocated to each of the top ten stocks. A high dividend yield automatically translates into a low stock price. These ten stocks were referred to as the ‘dogs’. This however does not ensure that they are dog like or cheap. It meant that they were high yielding, good stocks at battered valuations. The strategy does provide the kernel of a good idea. Why?

In a market like the current one, where all stocks seem to be moving up in unison, it is generally difficult to come up with a stock picking strategy that will beat the index. On the contrary when all stocks act independent of each other (like in 2013) there are generally greater opportunities for stock picking and hence out performance by skilful investors.

I proceeded to apply this strategy to the Indian market but with slight modifications. In India the financial year ends on 31 st March and dividends are accounted for in terms of financial years. Hence I have taken 31-3-2014 as the cut off date. As is my habit, I back-tested the efficacy of this strategy for the last five years. In the calendar year 2009, 2010 and 2011 8 of the top ten ‘dogs’ outperformed the Nifty. In the calendar year 2012, 5 of the top ten ‘dogs’ outperformed the Nifty. In 2013 this strategy failed, with only 1 stock outperforming the Nifty. The following table shows the top ten ‘dogs’ of the Nifty in the current year

‘DOGS’ OF 2013	DIV PER SHARE	PRICE ON 25/07/2014	% YIELD ON 31-3-2014	PRICE ON 31/03/2014	% RETURN
COALINDIA	33.30	377.00	11.53	288.75	30.56
NMDC	12.50	176.25	8.98	139.25	26.57
NTPC	6.00	148.95	5.00	119.90	24.23
PNB	37.00	923.70	4.97	743.90	24.17
BANKBARODA	32.50	862.15	4.51	720.75	19.62
CAIRN	12.50	308.70	3.75	333.00	-7.30
ONGC	9.75	401.10	3.06	318.70	25.86
SBIN	56.50	2500.55	2.95	1917.70	30.39
GAIL	10.10	427.80	2.69	376.05	13.76
HEROMOTOCO	60.00	2574.70	2.64	2274.80	13.18

As is visible 6 of the ‘dogs’ are outperforming the CNX NIFTY as on 25th July, 2014. Looking at the volatility in the market, it might be a good idea to monitor the top ten ‘dogs’ and buy them on corrections. This method can be used for stock selection or as an alternative strategy to buying an index traded fund / Index ETF. Looking at the speed of the corrections and pullback, it is always a good idea to be prepared when the opportunity arises. For a detailed analysis of the Nifty stocks till 25-07-2014 click here.

Dogs strategy – Pros & Cons

This strategy is often criticized as being arbitrary in nature and that it ignores growth, management etc. Yes, it is arbitrary, but not as arbitrary as the media channels and paid subscriptions on which many investors base their decisions.To the best of my knowledge most investors still invest in an arbitrary fashion. So this strategy is not as arbitrary as whatever strategy is currently in vogue.

There is nothing that suggests that this strategy has to be used at the beginning of the calendar year. In the current scenario, many of the stocks in the Nifty pay quarterly dividends. So one may, in fact, run this at the end of any given quarter. One has to be consistent though.

There is a fear that one ends up buying stocks whose potential earnings are forecasted as being weak. We all know how accurate forecasts are. What this strategy ensures is that one tends to buy good dividend paying companies at comparatively cheap valuations. In fact, a bad prognosis on a stock is generally one of the best times to buy it. Effectively, this is also one of the ways investors can hope to achieve their ‘buy low and sell high’ obsession.

The criticism against this approach is that it is equal weighted and the index is not. Also changes in the Nifty construction and weightage are not considered. However, each individual investor may change the allocation to suit his needs. Effectively, investors can tweak the strategy to their liking.
The strategy can be extended using other barometers. One may alternatively use price to book value or price to earnings.
There is an argument that picking a portfolio solely based on dividend yield is fraught with risk, since these stocks may just stop paying dividend. Investors should select stocks based on total return i.e yield and price appreciation. This is valid, but then investing is all about considering probabilities rather than trying to outmanoeuvre every possibility.

Conclusion

The reason why this strategy is likely to work in India are two-fold,

Dividends are tax-free in the hands of the shareholders. The promoters are the largest shareholders. Hence they stand to benefit the most. This ensures that we will stay in a dividend mould and not move towards a buy back mould as has happened in the U.S.
There is a tendency among most of us (me included), to be too negative on beaten down stocks and too positive on market darlings. There is a tendency to play the momentum. Since successful investing is all about making fewer and fewer mistakes, it is important to remember that failing to stick to a strategy is a mistake.

This strategy is counter-intuitive and so is the market. In a nutshell you are betting on stocks that are out of favour and hence relatively cheap. In addition to that you also get the dividends which are tax-free. Are the ‘dogs’ barking bargains for the financial year 2014-15?

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Dividends are tax-free in the hands of the shareholders. The promoters are the largest shareholders. Hence they stand to benefit the most. This ensures that we will stay in a dividend mould and not move towards a buy back mould as has happened in the U.S.