So I don't really see this as an especially spectacular strategy. Had I put my money into a Vanguard total stock index (Dow), dogs of the dow would have matched my returns I'd have come out ahead because of the lower fees. And since the Dogs is necessarily a smaller set of holdings, they're more volatile. I'd need to see a statistical analysis, but I really wonder if this set of 20, 40 or however many stocks has really significantly deviated from the returns you'd expect from 20-40 randomly selected stocks. In the end it doesn't support the idea that a typical investor would expect to outperform the market better than chance.
O'Shaugnessy in "what works on wall street" computed the result of "dogs of the dow" when compared to SP500 for a period between 1929 to 2004.
SP500 : 9.7%/year, sharpe ratio 0.38, min return -43.34%, max return 53.99%
dogs : 12.24%/year, sharpe ratio 0.49, min return -48.88%, max return 66.73%
That's a really big difference for such a long period. Fees must be included and will lower the return, but selling&buying between 0 and 10 securities per year isn't that expensive. Anyway, that strategy is far from being my favorite value strategy, but its the most famous one.
Can you define intrinsic, fundamental value of a stock for us in a quantitative way we could actually test it?
You could test something as simple as price-to-earnings ratio < 10. Or current price < 67% * tangible book value. These simple metrics have been advised by Ben Graham at least as early as the 1970s (maybe even earlier, I can't be sure) and have been checked in the following decades (so that's not just a happy result of datamining past returns). You won't become Warren Buffet just that way, but in the past (and I can't see why it won't happen again) you would have beaten the average by a few points each year.
And if it's just a super-magic-really-good "investor gut feel" to buy a certain stock that can't be quantified, surely some set of people have this talent and knack, right? A lot of those people are probably going to become fund managers and stock gurus. Hmm, but actively managed funds can't beat the index. And stock gurus, when they're actually making enough explicit stock picks, can be shown to do better than chance. So how can both be true?
Well, there's Berkshire Hattaway at least.
There are a few problems with value fund managers, actually. First, they can't buy really small caps, because the amounts of money they deal with don't let them buy enough stocks at the current price. Second, investors don't like their money to underperform the market two years or more in a row. But value investing is not a steady road ; it's a very long term, very volatile trip. You can have very bad performance for a few years but skyrocket the year after. Well, the problem is customers of your fund will hate you on bad years, and most of them will leave you then. Everybody said Buffet was "dead" in 1998-1999 because he was underperforming the dot.com investors.
Citation showing that value investments consistently outperform the markets needed.
Have a look at the tweedy, browne study (
http://www.tweedy.com/resources/library_docs/papers/WhatHasWorkedFundVersionWeb.pdf) that has tested various "value" metrics trough time. Joseph Piotroski's work are interesting too and point to many academic papers on that subject (
http://www.chicagobooth.edu/faculty/selectedpapers/sp84.pdf)
A market cap weighted index makes much more sense than an equal weight index as far as I'm concerned. Just because Apple's market cap is high, doesn't mean it's "expensive".
The problem is, if it gets significantly higher today because of a good news, its weight in the index will grow and tracker vendors will have to buy some more, thus driving it even a little higher. That doesn't sound efficient to me.
Index investing is shown as an obvious, no-brainer solution to invest in the markets. Well, it's not that obvious, it's a strategy per se : a momentum strategy. The more the price of a security grows, the more you buy it. That's not "natural", that's a strategy in itself. But as you point, equal weighting is not "natural" either, because small companies that don't have effects on the overall economy will impact your portfolio. There is no perfect, neutral, natural way to invest in the markets. All imply you follow a strategy. Index investing is one of them, no more, no less. It is in now way inherently better. It's just easier.
Smedleyb, I'm invested in French small-caps & micro-caps.
MooreBonds, you're right, that's why I prefer sticking to strategies that have been documented and checked in the past.