Every few years or so, the keepers of the Dow Jones Industrial Average freshen up its roster of stocks, whether the index needs it or not. Usually, as now, it needs it.
The news Tuesday that the index committee, now overseen by McGraw-Hill Co.’s (MHFI) Standard & Poor’s unit, is replacing Alcoa Inc. (AA), Bank of America Corp. (BAC) and Hewlett-Packard Co. (HPQ) with Goldman Sachs Group Inc. (GS), Nike Inc. (NKE) and Visa Inc. (V) prompted the standard chatter about why the inductees were chosen, why the ejectees got the boot and why other large companies were passed over.
It’s a pretty straightforward story along these fronts: The new entrants, which will officially be part of the Dow on Sept. 23, are more-dynamic industry leaders that better embody the global services-based and consumer economy.
The companies being removed also happen to have low share prices, their stocks averaging around $14. The Dow, the oldest major equity benchmark, is price-weighted, meaning stocks with higher dollar prices sway the index value more than low-priced stocks – an archaic method that owes to its creation in the days of pencil-and-paper calculations.
Most indexes – such as the S&P 500, on which trillions of dollars are invested to track – are weighted by company market value. As David Blitzer, chairman of the index committee, told CNBC, the three stocks removed represent only 3% of the Dow’s weight. With the incoming stocks averaging around $137, they would together make up more than 15% of the Dow today.
As for the prominent companies passed over, it’s also clear why: Apple Inc. (AAPL), Amazon.com (AMZN) and Google Inc. (GOOG), the biggest bellwethers bypassed, have share prices between $300 and $885 – simply too high to be part of the Dow, as they would exert undue influence on the index. These companies exemplify the current corporate fashion for shunning stock splits and tolerating – even flaunting – high share prices.
Beyond the obvious “whys” of the index shuffle, though, the changes suggest at least three subtler points about the economy and market.
The selection of Goldman Sachs tells us the financial crisis is a mere faint echo — notwithstanding all the anniversary-related noise swirling around — five years to the week after Lehman Brothers failed.
In late September 2008, as grave doubts about all investment banks’ viability buffeted Goldman, Warren Buffett’s Berkshire Hathaway Inc. (BRK-A, BRK-B) came to the firm’s rescue, buying $5 billion in preferred stock at a fat 10% annual dividend, a bold gesture of confidence that helped Goldman through the crisis. Now it is the one large, pure investment banking and brokerage firm, its leading franchise if anything improved due to the retrenchment of many competitors.
Sure, BofA also needed a massive government bailout, but it was already in the Dow (installed pre-crisis in February 2008) when the vulnerability of U.S. banking giants became clear. Blitzer mentioned that BofA’s business has huge overlap with that of Dow member J.P. Morgan Chase & Co. (JPM), diluting its value as representative of the financial sector.
Goldman, a stellar stock performer in the past year with a 39% gain, is best viewed as the “house” in the global capital-markets casino, mediating capital flows and corporate transactions across the world.
Of course, as shown by the ill-fated selection of BofA – and the 1999 entries of Microsoft Corp. (MSFT) and Intel Corp. (INTC) at the height of the technology bubble – anointment by the Dow keepers is sometimes a reward for yesterday’s winners rather than a harbinger of great things to come. Goldman, though, remains well-positioned in all its businesses, and its shares, which hit $165 in early trade Tuesday, are hardly excessively valued compared to its sturdy $142 in tangible book value.
Speaking of technology, the removal of HP is another rude reminder of just how old “Old Tech” has gotten. Though HP essentially founded Silicon Valley as a sub-economy, the tech conglomerate is in prolonged turnaround mode, and its business is simply too redundant with the Dow’s other mature tech components: Intel, Microsoft, International Business Machines Corp. (IBM) and Cisco Systems Inc. (CSCO).
Visa, with its massive debit- and credit-card processing breadth, better captures the real-time consumer and business economy and the services-at-scale nature of today’s best tech firms.
Nike, meantime, captures the global consumer as driver of world economic activity. It gets half its revenue from overseas, with the emerging markets a key propellant of the brand’s growth. Demand for running shoes these days says more about the economy that the production of Alcoa’s aluminum ingot.
While Buffett’s Berkshire can never be in the Dow due to price constraints, with the A shares priced at $170,000, Buffett’s wisdom is well-represented there. Berkshire owns nearly 10% of Goldman after converting warrants received with its ’08 investment. The company has owned Nike shares for years, to go along with Buffett’s longtime stakes in American Express Co. (AXP), Walt Disney Co. (DIS) and Coca-Cola Co. (KO).
So while the Dow might be "your grandfather's index," it's implicitly blessed by Uncle Warren.