Stock Quotes in this Article: DD, INTC, KFT, MCD, MRK, PFE, T

NEW YORK (Stockpickr) -- Roughly 20 years ago, investors started focusing on the " Dogs of the Dow ." These are the 10 highest-yielding stocks in the Dow Jones Industrial Average, and their above-average yield is often a sign of recent distress for the company involved. In theory, these high-yielders have been oversold (as the share price falls, the dividend yield goes up) and are most likely to outperform the rest of the Dow stocks in the next 12 months.

A clear pattern is emerging. The Dogs of the Dow outperformed the market in the first half of the 1990s and the first half of the last decade as well. Yet it underperformed in the second half of each decade. As we move through a fresh decade, that trend is intact.

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The Dogs of the Dow have returned about 10% thus far in 2011 (as measured by the 10 Dow stocks that offered the highest yield at the end of 2010), compared with flat results for the broader DJIA. McDonald’s (MCD), Intel (INTC) and Pfizer (PFE) have led the way, with each rising more than 15% thus far in 2011.

The outperformance is understandable. The Dogs of the Dow tends to do well when investors are defensive. So if 2012 brings another year of investor uncertainty, the current crop of Dogs may lead the market once again in 2012.

 

Buy the Basket or Cherry Pick?

The above-cited performance results were generated by a passive investment strategy that holds all 10 Dow Dogs. You could also look to try to cherry pick the stocks that you think have the greatest chance for capital appreciation.

For example, AT&T (T), Merck (MRK) and Pfizer offer very juicy dividends, but organic growth at each of these companies is quite anemic, and it's hard to see how investors will suddenly find these stocks to be more appealing.

 

Perhaps a wiser path is to focus on other top-10 yielders in the Dow, focusing on those companies that appear poised for more robust growth. The remaining Dow Dogs appear to offer better paths to capital appreciation as each is expected to boost sales between 3% and 9% in 2012.

Here’s a look at three companies that offer both a nice yield and decent growth prospects, perhaps making them the best way to pay the Dogs of the Dow strategy.

The Best Stock for a Parched State

Farmers in Texas hope that the drought of 2011 was a one-time event. Crops withered and died, and mud turned to dirt. Chemical giant DuPont (DD) may have just the solution to the prospect of on-and-off droughts. Its AquaMax drought-tolerant corn seed has proven very resilient in the most stressful environments, and farmers are expected to plant it on more than 1.5 million acres in 2012, up from just 100,000 acres this year.

It’s that bright outlook for Dupont’s Pioneer seed division that has Merrill Lynch calling this stock a top pick for the chemical sector with a $61 price target, roughly 30% ahead of current levels. Merrill concedes that global demand for industrial chemicals, coatings and materials division (which accounts for roughly half of sales) is likely to be just flat in 2012, but the more dynamic agricultural and biosciences divisions merit a more robust multiple. Merrill thinks that “investors are well compensated for an uncertain demand backdrop at 10.5x our 2012 EPS estimate.”

What can investors expect in terms of dividends? Well, the payout has been flat at $1.64 a share in 2008, 2009, 2010 and 2011. Yet a dividend hike may be on the way. That’s because profits have been rising at a steady pace, from $3.31 a share in 2010, to around $4 a share this year, and a projected $4.35 in 2012. Regardless, DuPont is one of the top-yielding chemicals stocks.

A hike in the payout, which would move the yield up above the current 3.4%, might be another reason to bet on this Dow Dog.

DuPont, which shows up on a recent list of 10 High-Quality Stocks for 2012, was also featured in "5 Big Stocks to Trade for Gains Into 2012."

A High-Tech Yielder

A rising payout can be expected from chip-making giant Intel (INTC), which has already seen a steady stream of dividend hikes, from an 8-cent annual dividend in 2003 to a current run rate of 84 cents. With $8 billion in annual free cash flow and more than $6 billion in net cash in the bank, Intel could afford to part with $6 billion every year if it so chose. That would translate into a $1.10 annual payout, good for a 4.4% projected yield. Intel is one of the highest-yielding electronics stocks.

Meanwhile, shares trade for a very reasonable 10 times projected 2011 earnings. That multiple is at the low end of the 10-year range, and a move up to a 13 or 14 multiple looks quite feasible once investors stop fearing that the European crisis will crush PC sales in 2012.

Looking further out, Intel is pushing hard to maintain its technology lead. The company is on track to spend roughly $10.5 billion in capital spending this year to boost manufacturing yields.

One big bet on Intel comes from Warren Buffett, whose Berkshire Hathaway initiated a new 9.3 million-share position in the stock in the most recently reported quarter. Intel also shows up on a recent list of 5 Cash-Rich, Low-P/E Stocks and was featured last week in "5 Big Stocks to Trade for Gains."

 

Kraft

Yet it is Kraft (KFT), another of Warren Buffett's holdings, that offers the best combination of safety and growth. The company’s broad line of food brands can weather any economic cycle, and Kraft’s steady international expansion is morphing the company from a so-so growth story into a pretty solid one. Sales are on track to rise 11% to 12% this year, with two-thirds of that growth coming from emerging markets. The firm now derives roughly 50% of its revenue from abroad and 25% from emerging markets.

Consensus forecasts of a slowing growth rate in 2012 look too pessimistic. After all, Kraft’s market share in most of the 60 countries it operates in is fairly small -- and as market share moves up to levels seen in Europe and the U.S., Kraft should see a nice top and bottom-line tailwind. Kraft has more than 50 distinct brands with at least $100 million in sales (11 of the brands, such as Nabisco, Oscar Meyer and Maxwell House, have more than $1 billion in sales).

Shares could get a solid lift in 2012 as investors better understand the value in Kraft’s distinct grocery and snack businesses. Those two businesses will be separated in 2012, and investors will need to determine what that means in terms of dividend payouts. Management could decide to trim the payout at each entity to retain cash for growth-oriented initiatives.

So this stock may not stay in the Dow Dogs group, but business separations often yield solid gains for investors that ride out the process. Kraft is one of the top-yielding food and beverage stocks and one of TheStreet Ratings' top-rated food stocks.

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At the time of publication, author had no positions in stocks mentioned.