The O'Higgins Method

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One of the features of finance that has laid the market low in the past couple of years has been a penchant for arcane complexity.

Investment bankers seem to think that creating an impenetrable mystique around what they do is a sure-fire way to convince clients to pay big fees. Not all investors, however, vote for complexity. Simple is sometimes best. Michael O'Higgins, for example, outlined a simple system for beating the market in his book, Beating the Dow, published in 1991.

This sets out the basics of the idea that an investor could outperform the market by using a simple selection method only once a year. O'Higgins is a Miami-based fund manager and stockmarket commentator, and a contrarian with a proven track record of good performance.

The system, which is essentially a variant of income investing, consists of taking the 10 highest yielding stocks in the Dow Jones index, and then investing an equal amount in the five that, at the time, have the lowest share prices in absolute terms.

The selections are then left alone for 12 months - with absolutely no tinkering allowed under any circumstances. At the end of the period, the performance is totted up, and the same exercise performed again with the capital and the income accumulated during the year reinvested in the new choices indicated by the system.

O'Higgins also argues that the system will work even for a single stock. In this case, we simply perform the selection as described previously and then plump for the stock with second lowest share price.

This is a type of contrarian thinking because the stocks that emerge from a selection system like this are often those that the market has written off, or that it believes are so financially insecure that they may be forced to cut their dividends.

Because the market often overdoes such pessimism, stocks like this are frequently priced too low. But the system only works if pursued with studiously inactivity and adherence to the rules.

O'Higgins tested his theory on US data over a lengthy period. He found that it resulted in an average outperformance of the market by more than five percentage points a year. He has also devised a system for using bonds as an indicator. He observed, for example, "throughout most of financial history, investors have been paid handsomely for taking the risk of owning stocks. If the earnings yield [of the stockmarket} is below the yield on AAA corporate bonds, avoid stocks and put your money into long-term Treasury bonds".

O'Higgins also noted, prior to the 2000 stockmarket setback that "most investors belong to a generation so unfamiliar with a downturn that they feel a prolonged stockmarket reversal of fortune could only happen in an episode of The Twilight Zone." That's hardly the case now, although paradoxically this may indicate that this "dogs of the Dow" approach, as it is called, is an idea whose time has come.

The system is, as its name suggests, based around the Dow Jones Industrial Average. This is a share price weighted index, with constituents that change relatively infrequently. The system is unlikely to work for the S&P 500 or any other broad based index with constituents weighted by market capitalisation.

In the UK, the only index that is directly comparable to the Dow is the now rather neglected FT30 share index. This is compiled on a very similar basis to the Dow, although much less widely followed. Picking FT30 shares according to the O'Higgins principles has, however, been demonstrated to produce outperformance - sometimes significant outperformance - on a fairly consistent basis.

Peter says

This system is a tried and true way of investing in high-income stocks with the instinctive added appeal that your broker isn't likely to get rich on the commission that your trading generates. I don't want to go into detailed figures, but it does seem to work most of the time.

And as, Michael O'Higgins observed, it is best applied when equity yields are some way above bond yields, as is the case now. The hardest part is disciplining oneself not to tinker or try to second guess the system.