There’s a dead-simple strategy for putting up market-beating returns.

It’s called the “Dogs of the Dow,” and it’s a stock-picking approach that’s easy to follow. It focuses on companies that have fallen out of favor with investors and are undervalued relative to other stocks in the Dow Jones Industrial Average (DJIA).

Here’s how it works…

The DJIA includes 30 blue-chip, high-quality companies. These are household names like JPMorgan Chase (JPM), Apple (AAPL), and Nike (NKE). All 30 members are profitable and enduring companies.

The Dogs of the Dow strategy involves picking 10 of the 30 companies at the end of each calendar year solely based on the dividend yield.

A dividend yield is calculated based on the annual dividend per share and the share price. So, a $1 dividend on a $20 stock is a 5% dividend yield. If the stock price falls but the dividend stays the same, the yield goes up.

Right now, the Dow Jones Industrial Average trades for 18 times next year’s earnings estimate. That’s about in line with the S&P 500’s 17 times 2023 estimate.

The real value, though, as I’ve shared with readers of Smart Money Monday, is in the small-cap index.

Specifically, the S&P 600.

Finding Winners in the S&P 600

The Dogs of the Dow strategy is dumb-simple to implement. It has also been historically profitable…

From the beginning of 2008 to the end of 2018, investors who started with $10,000 and held it in the DJIA would’ve grown their account to approximately $17,350.

However, an investor who followed the Dogs of the Dow strategy would’ve had an ending balance of $21,420, which highlights the value of adjusting positions once a year.

Now, with the Dogs of the Dow, you have 30 stocks to look at—all you have to do is pick 10.

The S&P 600 includes 600 companies, so identifying which ones to buy is not as easy.

In addition, small-cap companies don’t return all their profits to shareholders in the form of dividends. The best ones retain all that capital and reinvest at high rates of return.

However, I still like the idea of applying the Dogs of the Dow strategy to the S&P 600.

Which is why I’ve combed through the S&P 600 and picked three names that fit into a Dogs of the Dow-type strategy.

Criteria

To select these three ideas, instead of looking at dividend yield, I focused on earnings yield. That is, the inversion of the P/E ratio. Ten times earnings equals a 10% earnings yield. And 12 times earnings is an 8.3% earnings yield. The higher the yield, the cheaper the stock.

Second, I looked at return on equity. A good company earns a high return on equity… simple as that.

Lastly, I looked at each company’s balance sheet. How much debt does it carry? And especially, how much debt does it carry in relation to profitability?

I factored all these in and came up with a few small-cap ideas that are worth further consideration.

“Dogs of the S&P 600” Picks

The first idea: Shutterstock, Inc. (SSTK).

Shutterstock sells digital images, video, music, and other content to brands, businesses, and media companies.

The company trades for 13X next year’s earnings, which is about in line with the S&P 600. However, it’s a high-quality company that generates a 20% return on equity. The balance sheet has more cash than debt, and it’s made money every year since going public in 2012.

The second idea: Boot Barn Holdings, Inc. (BOOT).

Boot Barn is a specialty retailer of western clothing and work wear. It has over 300 stores and is continuing to grow its store fleet.

The company trades for 10X next year’s earnings, which is below the average for the S&P 600. Boot Barn is also a high-quality company. Return on equity is a whopping 38% on a trailing 12-month basis. The balance sheet is also strong, with no long-term debt outside of leases.

Like Shutterstock, Boot Barn has been profitable every year since its initial public offering (IPO). And since that IPO, revenue has grown from $345 million to over $1.5 billion.

There’s still growth in front of it. It’s a great “Dogs of the S&P 600” candidate.

The third and final idea is Installed Building Products Inc. (IBP).

Installed Building Products provides and installs insulation for residential and commercial builders.

The company has been a serial acquiror of other insulation companies for many years, having acquired well over 150 companies in the past few decades.

The business is cyclical, but that is more than factored into the price.

IBP trades for 10 times next year’s earnings. It’s a high-quality business, having generated a return on equity well over 30%. And the balance sheet is in good shape, with a net debt-to-EBITDA of under 2X.

On top of that, revenue has grown from $430 million in 2013 to $2.5 billion on a trailing 12-month basis.

In short, IBP is another solid pick as a “Dog of the S&P 600.”

If you’re looking for small-cap exposure into individual stocks, these three merit a deeper look. All three have the potential to outperform the broader market—and even the S&P 600—over the coming months and years.

With that, happy holidays! I hope you’re able to relax this week with friends and loved ones.

Enjoy the new year, and we’ll pick up in 2023 with your next Smart Money Monday hitting your inbox on January 9.

Thanks for reading,

—Thompson Clark
Editor, Smart Money Monday

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