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3 Stocks That Could Be Added to the Dow Next

Sean Williams, The Motley Fool

With the exception of the Dow Jones Transportation Average, the Dow Jones Industrial Average (DJINDICES: ^DJI) is America's oldest and most prized stock index. Despite a handful of glaring flaws, including the Dow's reliance on share-price weighting as opposed to market-cap weighting, many Wall Street professionals and retail traders look to the Dow for reassurance on the health of the U.S. economy and stock market.

Change is commonplace with America's most watched stock index

However, over its 122-year run as America's most watched stock index, the Dow has undergone plenty of change. Originally introduced as a 12-component index on May 26, 1896, it would later expand to 20 components in 1916, and finally to the 30 components we're familiar with today in 1928. Just one of those 30 stocks in the Dow on its expansion date in October 1928 still remains today: ExxonMobil, which back then was known as the Standard Oil Co. of New Jersey. 

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Image source: Getty Images.

Since May 26, 1896, the Dow has undergone more than 50 component changes to the index. A committee that meets a few times annually and decides whether or not to make changes attempts to present the best picture of the U.S. economy using only 30 stocks. This means packing the Dow with meaningful companies, while also attempting to represent as many sectors and industries as possible. It's not an easy task, and any number of changes in a company's corporate structure via a merger, spinoff, or perhaps just poor performance could mean the removal of a Dow component from the index.

Recently, we witnessed industrial conglomerate General Electric get the boot from the Dow after what was a more than 110-year run in the index. ExxonMobil still has another 20 years to go if it wants to top that mark set by GE. But General Electric's departure demonstrates that change is a relative constant in the Dow.

Earlier this week, I looked at the next three stocks that I believe have the best chance of being kicked out of the Dow, with DowDuPont being my likeliest selection. Considering that DowDuPont has plans to break up into three separate but focused companies by the first half of 2019, its relevance in the Dow could fall, prompting the S&P Dow Jones Indices committee to show the industrial giant the door. 

Which stocks could be added to the Dow next?

But the real question is: Which stock(s) could be the next to join the Dow?

While it's nothing more than dart throwing at this point, I have my eye on three possible substitutes.

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Image source: Getty Images.

Costco Wholesale

With plenty of healthcare and technology sector representation in the Dow, one interesting aspect about the index is that there's very little representation from the food industry. Yes, beverage giant Coca-Cola and fast-casual restaurant chain McDonald's are part of the index, but that doesn't tell us enough about the food industry or consumers' buying habits. That's why I believe the addition of Costco Wholesale (NASDAQ: COST) to the Dow would be a nice fit.

To begin with, approximately two-thirds of Costco's sales are food items, which would give the Dow a considerably more accurate representation of the food industry.

Secondly, unlike a majority of retailers, Costco isn't a company that relies on netting the bulk of its profit in two or three months out of the year. Most of its margin is derived from a membership fee charged annually to customers who wish to shop at its warehouses. This membership fee actually allows Costco's profits to front-run consumer purchases as opposed to lagging those purchases, as is common with mall-based retailers. That should allow for earnings consistency not often seen with consumer-based companies included in the Dow.

And finally, because these membership fees, which often have a very high renewal rate among existing members, provide the bulk of Costco's profits, the company tends to keep the margins on its food items razor thin. This can provide an even more accurate glimpse of how the food industry is performing, as well as how those prices are impacting consumer buying habits. Let's not forget that around 70% of U.S. gross domestic product is consumption-based.

With a $217 share price and a meaningful market cap of $95 billion, Costco would make for a smart addition to the Dow.

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Image source: Getty Images.

Medtronic

David Blitzer, managing director and chairman of the index committee at S&P Dow Jones Indices, opined in a statement when booting GE out of the Dow that "[C]onsumer, finance, healthcare, and technology companies are more prominent today." That's sort of a clue to Wall Street and investors that the committee will be looking to ensure strong representation in these sectors in the years to come. Assuming Pfizer gets the heave-ho at some point in the future, which I predicted as a possibility earlier this week, a possible replacement might be medical device behemoth Medtronic (NYSE: MDT).

Right now, the Dow is represented by five healthcare companies: the nation's leading insurer UnitedHealth Group, pharmacy giant Walgreens Boots Alliance, healthcare conglomerate Johnson & Johnson (NYSE: JNJ), and drug giants Pfizer and Merck. While most healthcare avenues are covered here, there's a redundancy with two drugmakers, Pfizer and Merck, in the Dow. Even with Pfizer being the larger company by market cap, it has the lowest share price in the index, making it potentially expendable (remember, the Dow is entirely a price-weighted index).

Medtronic would be a solid fit since it would be the largest pure-play medical device maker that the committee could add. Don't get me wrong -- Johnson & Johnson's global device unit is huge -- but it's not a medical device pure play. J&J has its hands in consumer healthcare products and drug development, as well. In fact, the percentage of Johnson & Johnson's sales derived from pharmaceuticals has been steadily growing for more than a half decade and nearly hit 50% of total sales in the second quarter. 

With Medtronic, the Dow would get a $120 billion company with a reasonably high $88 share price. More so, it would position the index to take advantage of an aging American population that'll likely require a growing number of medical devices to live longer and healthier lives. If Pfizer were to be shown the door, I believe Medtronic is a logical replacement.

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Image source: Facebook.

Facebook

Lastly, there's always the potential that social media kingpin Facebook (NASDAQ: FB) could get added to the Dow. Sporting the fifth largest market cap in the U.S. at $592 billion and a $208 share price, the argument can clearly be made that this is a relevant business.

According to the company's first-quarter operating results, there were an average of 1.45 billion daily active users, up 13% year over year, with 2.2 billion monthly active users. In fact, the company's four main assets -- Facebook, Messenger, WhatsApp, and Instagram -- represent four of the seven most visited social media sites in the world. That type of relevance shouldn't be overlooked by the S&P Dow Jones Indices committee.

However, Facebook has two knocks against it that could thwart its addition to the Dow. First, it's a relatively young company. Even though it's been dominant, Facebook only debuted six years ago as a publicly traded company. The committee generally only adds companies after they've demonstrated that they have a time-tested business model. We're not exactly there yet with Facebook.

The other issue is that there are already six technology stocks represented in the Dow (note, I'm lumping Apple in as a tech stock, even though it's occasionally referred to as a "consumer goods" company). That's 20% of the index. If a company like IBM, which has struggled to keep up with the changing tech landscape, were shown the door, then a company like Facebook would be a potentially logical addition. But without removing any tech stocks, it could be a tough sell to get Facebook into an already tech-heavy Dow.

Still, it's hard to ignore a company worth $592 billion with a huge economic moat -- meaning there's still a chance Facebook gets the call during the next round of changes.

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Sean Williams has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Apple and Facebook. The Motley Fool owns shares of Johnson & Johnson and Medtronic and has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool recommends Costco Wholesale and UnitedHealth Group. The Motley Fool has a disclosure policy.