In a recent article, we looked at the traditional approach to a trading strategy known as the Dogs of the Dow. Several readers have questioned how a simple strategy like the Dogs can work. In this article, we will explain why the Dogs of the Dow can work and look at a variation of the Stock trading tips that can be implemented at a relatively low cost.
A common question among investors is how a strategy can work when a large number of investors already know about it. Researchers have shown that if a strategy is based on sound investing principles, it can work no matter how well known it is. This idea applies to the Dogs theory which has been well known for many years. Although most investors believe the theory dates back to the 1991 book Beating the Dow by Michael B. O’Higgins, we showed in our earlier article that the strategy was actually first written about in the June 1951 issue of the Journal of Finance. Although the strategy has been available to investors for more than 65 years, it still works because it is based on sound investing principles. Those principles are diversification, time and value.
First, the Dogs is a diversified strategy with five or ten holdings. It is important to hold several stocks within a strategy because any one stock can deliver a loss. On the other hand, any stock can deliver a gain. By diversifying, investors increase the probability of owning a stock that delivers a gain.
Second, this strategy gives stocks time to go up. Over the past twenty years, as the internet allowed investors to obtain real-time quotes and place trades quickly, expectations for rapid returns seem to have become common. During the bubble of the late 1990s, some day traders believed they could consistently achieve triple-digit gains and retire after just a few years of trading. Many of these traders lost large portions of their portfolios when the bubble ended and the market crashed. Since that time, general expectations of investors seem to have become more realistic but there are still many traders targeting large gains in short time frames. This is possible with some strategies but for many investors, it could be best to take a longer term perspective like the one-year perspective of the Dogs strategy.
A longer term perspective, expecting to hold positions for months or even a couple of years, can provide individual investors with an edge over Wall Street firms. Big firms are often highly leveraged and to manage risk, they need to trade short-term strategies. They might spend millions of dollars and devote thousands of hours to develop high frequency trading strategies. Then, they spend even more money to obtain detailed market data that allows them to execute trades in less than a second. As individual investors, we simply cannot compete with Wall Street firms in this time frame. By slowing down and looking at longer term opportunities, we can compete and find market-beating returns with sound strategies.
The rules of the Dogs of the Dow holds positions for a year, providing enough time for a stock to deliver a significant gain. And, perhaps more importantly, the rules of the strategy also prevent the mistake of taking profits early and missing out on big moves. This is a common mistake of individual investors who take profits too quickly on winning trades.
Third, the Dogs strategies are all based on value. As Warren Buffett notes, “price is what you pay, value is what you get.” We need to focus on value as investors to obtain market-beating results.
In the long run, value strategies applied with discipline and patience have been shown to outperform the market. Studies have shown this is true no matter which measure of value is used. Investors have found success buying stocks with high dividend yields, low price-to-earnings (P/E) ratios, low price-to-book (P/B) ratios, low price-to-sales (P/S) ratios and other valuation metrics.
For the Dogs strategies, investors often use the dividend yield to define value. This has the added benefit of providing income while waiting for capital gains to develop when the stock price rises. Dividends also decrease the downside of losses since the income offsets a portion of the loss.
But, the 1951 Journal of Finance article used P/E ratios and demonstrated any valuation tool could be used. This week, we looked at using the price-to-free cash flow (P/FCF) ratio and developed a low-cost Dogs strategy.
Free cash flow is the amount of cash a company has left over after paying for the cost of operations and making required reinvestments in the business. It is not a widely-followed measure like earnings or the dividend yield but FCF may be important than those metrics. FCF measures how much money the company has left over to pay for growth opportunities and to reward investors. Potential acquisitions or construction of new factories can be funded by FCF. Dividends and share repurchase programs can also be funded with FCF. Because FCF is used to fund the items that increase long-term shareholder value, it may be among the most important fundamental values even if it isn’t widely followed.
In the opinion of some analysts, FCF is the only forward-looking measure of value since earnings, book value and other items in the financial statements are all determined by what happened in the past. FCF can be thought of as determining the future. Not surprisingly, given this fact, P/FCF has been shown in academic studies to be a reliable predictor of future stock market performance.
The stock market can be your best place or your worst enemy. Having said that, some of the best stock trading tips even today is learning to play by the rules. Over a period of time, it does get easy to know a few tricks of the trade, however; this industry is such that nobody can ‘master’ it. The reason is that the stock market scenario is constantly changing and growing too. This is also one of the reasons why it makes for one of the best places to invest your money in. Either way, it helps to know a few basics about the stock industry before stepping in it.
Here are some of the best stock market investment tips to help you in 2018:
- Don’t go with the crowd:
As Warren Buffet quote "Be fearful when others are greedy, and be greedy when others are fearful!" When it comes to the stock market it is bad to be influenced by others. Although taking advice from someone can be a good thing, don’t completely direct your actions per their words.
- Take a planned decision each time:
The right way to go about with investing in stocks is to do your research and study about the company. Simply going by the brand name or peoples suggestions could be harmful in the long run and is best avoided.
- Step into a business that you are knowledgeable about:
This is very simple: the more you know about a business, the better you are going to be at it, be it managing or trading stocks. Go by your knowledge of what the industry or company is about and half the work is already done. While experimenting is healthy, this is crucial while starting out.
- Don’t stick to timelines:
Do not time the stock market. Do not even restrict yourself by schedules and time by when you should invest or expect returns. Go with the flow and understand that returns always take time and patience.
- Be disciplined:
Do not rush or try to get things going. Be disciplined with your actions and mostly abide by rules. This market focuses a lot on time and discipline and thus, returns too, reflected in the same way.
- Be practical, always:
Most people can be easily thrown away because of their emotions like greed and haste getting the better of them. In the end, trading is a skill and only happens when you are calm, practical and can restrict sentiments.
- Broaden your horizon:
Once you determine your investment power and the risk factor in a business, investing can be done in a number of industries after careful consideration. Broadening your reach will only end up making you more confident and a better decision maker as you move ahead.
- Do not be unrealistic:
Understand that not all companies, scenarios or structures are same so of course; investments and their returns will differ as well. Keep an open mind, a skilled concept and hope for the best each time.
Apart from this, investing in the stock market always comes with a learning curve. Going forth, make your decisions, see how they work out and then take appropriate steps in the future. You can also say that some of the truly best way to trade stocks that work in the stock market haven’t even been discovered yet. So go ahead, give it your best shot and no matter what, take pride and let honesty be your way to go each time you are investing.