Dogs of the FTSE 100 on winning form again

It pays to insure your portfolio - or at least that was the case for our sister publication Money Observer's Dogs of the Footsie portfolio last year. A big rise in the shares of three of its biggest insurance companies - Standard Life, RSA Insurance and Admiral - helped its collection of unloved companies romp across the finishing line in 2012/13.

The Dogs enjoyed their best performance since the stellar year of 2009 with a gain of 10.1% compared with an 8.4% rise in the FTSE 100 index. Add in dividends, and the Dogs were even further ahead, with an 18.3% return compared with 12.6%.

Regular readers will be familiar with the Dogs strategy, which has been running for more than a decade. A straightforward dividend-based value strategy, it is compiled by selecting the 10 FTSE 100 companies offering the highest yields and holding them for a year.

It has proved a winning formula: the Dogs have beaten the market in nine of the 13 years it has been followed. While it did very badly in the stockmarket carnage of 2007 and 2008, when dividends were cut across the board, the good years compensated for that.

If you had followed the strategy over the 12 years since monitoring its total return, you would have made an average return of 7.3% a year, on a share price basis, and 13.6% total return. That compares with just 1.7% and 5.4%, respectively, for the FTSE 100 index.

The logic is that a high yield can be an indication that the company is out of favour with the market but, as sentiment changes or its performance improves, its shares will recover and its yield fall. Because the constituents are drawn from the largest companies in the country, there is virtually no risk that they will go bust, while a portfolio of 10 should be large enough to mean that one or two bad performances will be outweighed by gains elsewhere.

That was the case a year ago, when the portfolio was dominated by financial stocks. Half of the portfolio rose faster than the FTSE 100 while the other half lagged behind. This time last year, investors were fretting about the future of the euro and the stability of its banks, and the ability of governments to stave off financial collapse. Stockmarkets were depressed and insurance companies, whose assets are tied to the market's fortunes, were also looking financially stretched and their dividends unsustainable.

A year on, while the crisis has not been resolved, there is a lot more confidence in the future of the euro and the ability of politicians to handle the crisis. While some insurers' dividends still look rather too generous, a more buoyant stockmarket and relative calm on the European front has helped their shares recover some ground.

Not all the financial companies have shared in the recovery, however. Man Group is still struggling to demonstrate that its hedge funds can once again deliver decent returns and, while it has said it will hold its dividend, investors are not convinced this will be possible over the long term. That made it the worst performer in the portfolio with a share price decline of more than a quarter.

Of course, a high yield can also be an indication that the dividend is under threat - and, once again, there are doubts over the sustainability of the dividends of many of the companies in the 2013 Dogs portfolio. In fact, none of last year's Dogs did cut their payouts but history suggests that, even if a cut does actually happen, it can enhance, rather than detract from, performance as investors express their relief that the yield uncertainty is over.

The Dogs strategy originated in the US. However, the Dogs of the Dow, as they are known, have not proved successful: in 2012, the American dogs made a total return of 9.6% compared with 11% for the Dow and 13.4% for the S&P 500. But the Dow Jones Industrial Average, from which the Dogs are sourced, has just 30 stocks and they are rarely changed; the FTSE 100 membership is more than three times as large, and companies come and go depending on their market capitalisation.

The healthy dividend growth seen in the past two years is expected to slow this year: Capita Registrars is forecasting a 3% increase in dividends in 2013, a dramatic fall from the 15.6% rise seen in 2012. If the US recovery continues, and investors' risk appetite continues to increase, the kind of defensive stocks that generally pay good dividends could lag the more cyclical companies.

History has shown, however, that the Dogs of the FTSE can perform in any climate. Anyone looking for an investment opportunity could benefit from a flutter on the Dogs.

Other income and value strategies to consider

The Dogs of the FTSE may produce good results but it is a very crude tool: yield is the only screen used so it pays no attention to the safety of the dividend, the company's financial health, prospects, rating or any of the other analytical tools in investors' armour.

There are plenty of other strategies filling that gap. Stockopedia, the website specialising in screening strategies for investment portfolios, offers a wide range of income- and value-based strategies. Two of the more successful take yield as their starting point but add a number of refinements, and screen a wider range of stocks.

Stockopedia's chief executive Edward Page-Croft says: "The main issue with [strategies such as] the Dividend Dogs of the FTSE/Dow approach is that they focus on the highest-yielding 10 stocks of the index, which come with a much higher risk of dividend cuts. The financial crisis and the current era of low returns put a far greater focus on dividend sustainability."

The first of Stockopedia's strategies is the Quality Income portfolio, based on research by the global strategy team at Société Générale.

The aim is to uncover high-quality, low-risk stocks that are sustainable dividend payers. It uses five filters: three of which are straightforward - companies must not be in the financial sector; the yield must be between 4 and 15%; market capitalisation of at least £800 million - and two a bit more esoteric; the Piotroski F-Score must be at least seven and the Altman Z-Score above 1.8. Neither of these scores will be common currency among amateur investors: the first is a measure of the financial health of a company, based on factors such as return on assets, cash flow and changes in debt levels; the second is a bankruptcy risk indicator that uses five ratios including working capital to total assets and net sales to total assets to predict the risk that the company will fail.

It has been pretty successful: over the year to 31 January 2013, it produced a share price return of 24.85% compared with 10.68% for the FTSE 100, and the annualised return since its inception in December 2011 has been 27.27%. SocGen's own research has tested the approach back to the beginning of 1990 and calculates that the Quality Income index would have produced a total return of 11.6% a year since then.

Among the 14 companies in the portfolio on 1 February were utility SSE, tobacco company British American Tobacco, printer De La Rue and investment holding company Zhejiang Expressway.

The second Stockopedia strategy is the Dreman High Yield portfolio, based on the work of contrarian investor and author David Dreman. It uses seven criteria, some of which private investors can easily calculate and some rather more complicated: yield within the top 20% of the universe; sales greater than £100 million; the ratio of debt to assets less than the median for the market; a current ratio - debt to assets - of more than one; net margins and earnings per share growth above the market median; and it must not be an investment trust.

Over the year to the end of January, it has returned 36.1% and the annualised return since Stockopedia established the portfolio in December 2011 has been an impressive 47.2%. Among its 14 components at 1 February this year were floor covering group Headlam, retailer Majestic Wine and phone group Telecom Plus.

Stockopedia offers subscriptions for £19.99 a month - or you can chose simply to set up your own dog pack: while it is less scientific, it has proved reasonably successful over the past 13 years.