The “Dogs of the Dow” strategy consists of buying a basket of the cheapest stocks out of the 30 components of the Dow Jones Industrial Average. One of the more popular strategies in recent years has been to buy Dow stocks with the highest dividend yields. But past strategies, including one highlighted by legendary value investor Benjamin Graham, focused on Dow stocks with the lowest earnings multiples.

A cornerstone of the strategy is that the cheapest stocks in the Dow will eventually see a reversal of their fortunes and will soon trade more in line with the other stocks in the Dow. Michael O’Higgins is credited with popularizing the Dogs of the Dow Theory and has written books detailing the strategy’s success in the 1990s. Graham cited periods between the 1930s and 1970s when the strategy paid off. More recent studies don’t exist, but in general, buying firms with solid growth outlooks that trade at low valuations can pay off in any market environment.

With that, below are three of the cheapest stocks in the Dow based off their price-to-earnings (P/E) multiples.  

1. Hewlett-Packard (NYSE: HPQ)
Business: computers, printers, technology services
Forward P/E: 7

Hewlett-Packard has gone through a volatile period. Former CEO Mark Hurd was replaced over allegations he had an inappropriate relationship with a contractor and other minor expense report offenses. Hurd was popular on Wall Street for his cost-cutting moves while at HP but apparently was not doing so internally and was replaced with former SAP (NYSE: SAP) CEO Leo Apotheker in September 2010.

The internal instability has knocked the stock down to a single-digit P/E multiple, making it the cheapest in the Dow. This represents a potential buying opportunity, as the firm’s operations remain stable and have plenty of room for growth. HP is one of the largest tech firms, with sales in excess of $126 billion in 2010. Nearly 65% of sales are from overseas. The company has leading market share in computers, printers, servers and high-margin services. Last year, it reported $3.69 in diluted earnings per share and has aggressive targets to reach $7 in earnings by 2014.

HP plans to achieve this profit growth by aggressively moving into cloud computing and ensure that its printers, PCs, smartphones and services all adapt to a continued migration of technology online. It also plans to augment internal growth with acquisitions, such as the September 2010 purchase of 3PAR to beef up its online storage capabilities.

2. Chevron (NYSE: CVX)
Business: Large oil and gas
Forward P/E: 8.1

Chevron is a top-five oil firm, given its vast reserves of oil and natural gas. Growth during the past decade has been stellar, as sales have improved 15.5% and earnings by 17.5% on average each year in the past decade. Growth is projected to continue apace, with the earnings consensus for this year at $12.12 a share, or nearly 30% above last year’s levels.

At the current price, Chevron offers the solid combination of a low earnings multiple, a decent dividend yield of 2.7% and strong projected growth. And nearly 60% of last year’s stales stemmed from overseas, giving the company exposure to faster-growing regions outside of the United States.

3. Pfizer (NYSE: PFE) and Merck (NYSE: MRK)
Business: Branded pharmaceutical drugs
Forward P/E: 9 and 8.9

Pfizer and Merck are the next two cheapest stocks in the Dow, based on forward earnings, and have equally-compelling investment appeal in the health care industry. Both have had their past struggles, as leading drugs have lost patent exclusivity and both are set to lose another set of blockbuster drugs in coming years. Pfizer faces the imminent expiration of cholesterol-lowering drug Lipitor’s patent this year, while Merck is set to lose allergy-treatment drug Singulair to generic competition in 2012.

This steady wave of expirations is still fresh in investor’s minds and sentiment has become too negative. Pfizer is projected to report $2.24 in earnings per share this year, which is about flat with 2010, but it should be able to post double-digit growth during the next few years, as the acquisitions of Wyeth and King Pharma have added strong current drugs such as Enbrel, used to treat autoimmune disorders such as arthritis, as well as candidates in the painkiller and biologic categories.

Merck is projected to grow earnings almost 8% from 2010 to $3.69 per share and should also be able to boost profits steadily in the next few years. The company is wringing out costs from the $41 billion acquisition of Schering-Plough in 2009 and also has a strong lineup of products, including diabetes drug Janumet, and Isentress, used for the treatment of HIV. The stock also boasts an impressive dividend yield of 4.5%, while Pfizer’s is still decent at just less than 4.0%.

Action to Take —> Hewlett-Packard should rally strongly if the company can prove to investors that the growth strategy to achieve $7 in earnings per share by 2014 is paying off.  Chevron should continue to post strong earnings growth, meaning the earnings multiple can stay the same and still make money for investors. Like HP, Pfizer and Merck have to prove to investors they have turned the corner to consistent sales and profit growth, and both can rally big on earnings growth and as the multiples expand to more closely match the other companies in the Dow.

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