Is it time to start buying the FTSE’s Dividend Dogs?

The return of useful interest rates on cash savings has provided an additional choice for income-seeking investors.

But despite the 4%+ risk-free rates available today, I think that an equity income strategy  is likely to remain a better choice for investors seeking income and long-term capital growth:

Date: 14/10/24

The impact of compounding means that an investment made at 8% will be worth more than double an investment at 4% after 20 years:

• £10,000 invested at 8% would be worth £46,609 after 20 years

• £10,000 invested at 4% would be worth just £21,911 after 20 years

Inflation is another factor to consider. With UK inflation still running at around 3%, cash savings at 4% aren’t technically falling in value. But they’re not growing much, either.

I reckon that owning a selection of FTSE 100 shares with above-average dividend yields could be a simple and relatively hassle-free way to invest in UK equity and generate a competitive level of income.

The FTSE 100’s recent gains (14% in the last year) have pushed the index’s average dividend yield down to 3.6%.

However, significantly higher yields are available from individual stocks in the index. At the time of writing, the FTSE 100 contains 40 stocks with dividend yields over 4%.

In the remainder of this article, I’ll take a look at a simple high yield strategy that has been outperforming and currently offers a 7% average dividend yield.

Should we take a fresh look at the Dividend Dogs?

The Dividend Dogs strategy is based on a famous approach by US investor Michael O’Higgins in his book Beating the Dow.

The strategy simply involves selecting the 10 highest-yielding shares from a big cap index and rebalancing them annually.

In essence, it’s a contrarian strategy. The idea is that the investor is buying shares in mature, successful companies that are likely to be able to survive any temporary headwinds that have depressed their share prices. Over time, many should re-rate to more average valuations.

The Dividend Dogs of the FTSE 100 is one of the income strategies available in Stockopedia’s Guru Screens.

At first glance, the performance of this strategy since its inception in December 2011 looks underwhelming.

The Dogs have underperformed the FTSE All-Share index over this period, generating a capital gain of just 45% over nearly 13 years. That’s equivalent to an annualised gain of 3%:

Dividend Dogs = dark blue line

However, the result pictured above does not include dividend returns – a key part of this strategy.

I don’t have the ability to model the results with stock-specific dividends, but the overall FTSE 100 yield has averaged about 4% over this period. Adding this improves the total annualised return of this strategy since 2011 to the long-term market average of c.7%.

Furthermore, I think it’s fair to assume that the Dividend Dogs will generally offer a yield comfortably above the FTSE average.

On that basis, I would argue that the Dogs strategy may actually have performed quite well over the last decade.

A turning point?

One thing that’s certainly true is that the performance of the Dividend Dogs has improved markedly since interest rates started to rise in 2022.

Whether that is coincidence or causation, I am not sure. But the Dogs have outperformed the wider market over the last two years with a capital gain of 33%, versus 21% for the FTSE All-Share:

The 10 stocks in the Dividend Dogs model portfolio today boast an average yield of around 7%. Given the blue chip nature of the companies that qualify for this screen, I think this strategy could be worth a closer look in the current market.

Let’s take a look at the current results of this screen.

Dividend Dogs: screen results

You can see the current results of the Dividend Dogs strategy here. The screen simply sorts the FTSE 100 by yield and then selects the 10 highest yielders:

Note: this version of the screen uses the current (historic) dividend yield, not the forecast yield. FTSE 100 companies often flag up dividend cuts in advance, but these aren’t reflected here.

An example of this is Vodafone (LON:VOD). The company has already said that its dividend will be cut by 50% from the 24/25 financial year. So the 10% yield indicated above is actually a 5% dividend yield.

Is this selection suitable for a readymade portfolio? Here are a few observations.

Diversification: there’s no escaping the lack of diversification in this screen results.

Half the companies listed are financials. Phoenix group (LON:PHNX), M&G (LON:MNG), Legal & General (LON:LGEN) and Aviva (LON:AV.)  all operate in overlapping areas, albeit with some differences too.

Elsewhere, both of the FTSE 100’s Big Tobacco stocks are listed here.

Some diversification comes from the presence of Vodafone, Rio Tinto (LON:RIO) and Taylor Wimpey (LON:TW.), albeit all three are cyclical businesses.

However, even without this year’s dividend cut, Vodafone has a long track record of destroying shareholder value. Whether the group’s profitability can improve sufficiently to reverse this is not yet certain, although personally I am cautiously optimistic about the changes taking place under the current CEO.

A poorly-diversified portfolio of 10 stocks sounds like a bad idea, and perhaps it is.

But these are all FTSE 100 companies and this portfolio would be rebalanced annually. In my view, this selection is not necessarily as risky as it might seem.

Dividend safety: dividend yields of more than 6% are often seen as being at risk of a cut. Is that true here?

Perhaps. But again, I don’t think these payouts are necessarily as risky as their high yields might suggest.

While individual investors are unlikely to be able to model the future cash flow of a large financial business, most of these companies do provide clear guidance on their expectations for the next three to five years.

In the majority of cases, I have found this guidance to be fairly credible and accurate in recent years. Phoenix is a good example of this, in my view.

The big tobacco stocks won’t suit everyone, but they also remain reliable engines of cash generation. Of the two, I prefer Imperial Brands (LON:IMB) at the moment, but the larger next-gen business and different geographical exposure at British American Tobacco (LON:BATS) may turn out to be advantageous over time.

Rio Tinto, Vodafone and Taylor Wimpey all have a reputation for prioritising dividends, albeit cuts have periodically been needed to address cyclical conditions.

What about the forecast Dividend Dogs?

Stockopedia also offers another version of the Dividend Dogs screen, based on forecast dividend yields instead of historic payouts. You can see this screen here.

While broker forecasts are never guaranteed, FTSE 100 shares are heavily covered. Surprise dividend cuts for the current year are relatively rare, in my experience.

The list of 10 stocks that qualify for this screen overlaps heavily with the historic Dogs above, but also includes several stocks that don’t appear. I think there are some interesting new additions:

This selection is also weighted towards financials and tobacco stocks. But the other companies listed look interesting to me and add some useful diversification. In particular, I would view B&M European Value Retail SA (LON:BME) and Land Securities (LON:LAND) as sensible choices for income right now.

Using the StockRanks as a filter

If I wanted to build a Dividend Dogs portfolio, what I might do is to combine these two screen results and then sort them by StockRank.

Here’s how this would look in a dummy portfolio:

A simple approach might be to buy the 10 highest-ranked stocks from this list, rebalancing annually.

Using the list above, following this approach would give an average forecast dividend yield of 7.3%, spread across seven different types of business.

I think that this could be worth a closer look. Indeed, I might consider setting up a model portfolio along these lines.

Disclosure: Roland owned shares in Legal & General and Imperial Brands at the time of publication.