Friday, September 13, 2013

Dow Jones Adjusts Roster

On Tuesday, it was announced that some roster changes would occur among the 30 components that make up the Dow Jones Industrial Average (DJIA).

What's in:
Goldman Sachs (GS)
Nike (NKE)
Visa (V)

What's out:
Alcoa (AA)
Hewlett-Packard (HPQ)
Bank of America (BAC)

The changes become effective on September 23rd.

This Barron's article explains why the recent changes to the widely known index might be ill-advised.

It's not difficult to argue that, even before these changes, the index had a more than somewhat bizarre weighting for its components.

Well, the recent changes certainly haven't come near to solving that particular fundamental problem.

The Barron's article points out the following:

- Five stocks will now make up roughly 33% of the index.

- Four stocks will now make up less than 5% of the index due to their relatively lower stock prices.

Now, consider that the combined market value of the five stocks is ~ $ 720 billion, while the combined market value of the four stocks is ~ $ 670 billion.

So maybe not quite an equal combined value, but close enough that the 33% versus the less than 5% weighting plainly makes little sense.

In fact, those four stocks that make up less than 5% of the DJIA have nearly 9x the combined market value relative to Goldman Sachs alone.

Yet they'll have less influence on the DJIA than the investment bank.

At first glance (and, well, even a second one) some rather tortured logic appears required to explain why such a weighting discrepancy should exist in a closely-watched benchmark.

This all comes down to the DJIA being a price-weighted index instead of a capitalization-weighted index.

The index has each of its 30 components weighted by their stock price.

So it is a bit of a strange index.

At current prices, IBM (IBM) has the largest influence on the index (followed by Visa then Goldman).

Microsoft (MSFT), with more than 3x the market value compared to Goldman, will have roughly one-fifth the influence due to the price weighting.
(Goldman's shares price is roughly $ 163; Microsoft's is closer to $ 33.)

The list of quirks like this related to the weighting by price goes on...

Visa and Nike are fine businesses, and certainly seem to be reasonable additions, though it's worth mentioning they seem not at all cheap.

Both companies sell at P/E ratios comfortably north of 20x.

Goldman, on the other hand, seems an imperfect choice considering alternatives. It's not a traditional bank that mostly makes its money from lending and related services. Instead, it is primarily involved in trading and related activities.

That kind of activity certainly has its place in the world but hardly makes Goldman the ideal candidate.

To me, there are other public companies that provide more broad-based insight into the U.S. economy.

The fact that Goldman will have an outsized impact on the index because of its stock price only makes the situation worse.

The removal of Alcoa seems a vast improvement and long overdue. Its low stock price has meant its influence has been small. There are, and have been, many superior blue chip companies out there to take its place.

With J.P. Morgan Chase (JPM) already in the index, it's not hard to understand the removal of Bank of America.

Hewlett-Packard has had its fair share of difficulties but, with several big cap tech companies already in the index, it also seems sort of redundant.

Of course, HP is selling for an extremely low multiple and at least so far, despite the difficulties, has continued generating lots of free cash flow. On a multiple of earnings basis, both Visa and Nike would need to roughly triple their earnings before they catch up to what HP is already earning now.
(And/or HP earnings could shrink, of course.)

So Visa and Nike have a much greater index weighting with much less earning power. I can understand a growth argument here, but that's a whole lot of growth just to catch up earnings-wise.
(Or, again, some kind of collapse in earnings for HP.)

The bottom line is that the stocks being removed have an average price of $ 15/share while those being added are more like $ 140/share. This should be irrelevant but, due the price weighting, it is not.

The Barron's article argues that Berkshire Hathaway (BRKb) would make a logical addition since it has broad exposure to many aspects of the U.S. economy.

Hard to disagree with that.

It would need to be the Berkshire Class B shares of common stock, of course. At roughly $ 170,000 per share, the Class A shares would totally dominate the price-weighted index.

Economically, the Class B common shares are equal to 1/1,500th of the Class A common shares.* So, at more like $ 113/share, they'd work just fine.

DJIA remains quite an idiosyncratic index yet, for many, it remains the proxy for overall stock performance and the U.S. economy more generally.

Despite its oddball weighting system, for better or worse, it's still a widely followed index even if less so for Wall Street these days.

Here's one way to gauge this. Apparently, something like $ 30 to 35 billion is indexed to the DJIA while approximately $ 1.6 trillion is indexed to the S&P 500.

So only 2 percent or so as much in funds is indexed to the DJIA versus the S&P 500.

Adam

Long HPQ, BAC, IBM, MSFT, JPM, and BRKb

* Though the Berkshire Class B shares have only 1/10,000th of the voting rights compared to the Class A shares.
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