The Dow Becomes Less “Industrial” and “Average”

The Dow Jones Industrial Average is going through another shakeup.

Three members of the 30-stock index are being replaced: Alcoa (NYSE: AA), Bank of America (NYSE: BAC) and Hewlett-Packard (NYSE: HPQ). Their replacements are Goldman Sachs (NYSE: GS), Nike (NYSE: NKE) and Visa (NYSE: V).

The switches will go into effect at the start of trading on Monday, Sept. 23 It’s the largest revision to the index since April 2004.

Adjustments in the Dow’s makeup have considerable symbolic significance. The Dow is the nation’s oldest and most popular index. It began in 1896 with 12 stocks, including General Electric (NYSE: GE), the lone original still there.

The Dow is closely watched as a barometer of the broader market. When people want to know how the stock market is doing or what it did today, the answer usually is “The Dow is up 100 points” or “The Dow dropped 50 points.”

But replacements are less important for the individual stocks. There’s little need to buy or sell based on the changes because relatively few investment products track the Dow. Switches in such indexes as the Standard & Poor’s 500 and Russell 2000 are meaningful for the new and old components because there’s a lot of money in products that are linked to these indexes.

The changes “were prompted by the low stock price of the three companies slated for removal and the Index Committee’s desire to diversify the sector and industry group representation of the index,” said S&P Dow Jones Indices, the company that oversees the Dow.

The stated wish to diversify the index leaves it even less industrial than before.

Alcoa, a Dow member since 1959, has long grappled with a global slump in aluminum demand. The stock is down 83 percent from its 2007 peak.

Hewlett-Packard was only the second computer company in the Dow (after Interna! tional Business Machines (NYSE: IBM) when it was added in 1997). Now it’s fighting to turn around its business. Despite a strong rebound this year, the stock has fallen 66 percent from its all-time high set 13 years ago.

Bank of America entered the Dow in February 2008, during the early stages of the financial crisis, which was strange timing to say the least. BAC also has struggled, although the stock is up 80 percent over the last 18 months.

The three new stocks are of two financial companies and a sports-apparel company whose goods are made overseas. All three are leaders in their fields, and their shares have done well. Visa and Nike, in particular, inject some needed growth potential into the Dow.

Still, as one observer put it: “When you get put in the Dow, it is a lagging indicator. It means you’ve already succeeded. It’s like getting elected to the Hall of Fame.”

The strangest thing about the Dow is that it’s a price-weighted index, so the stocks with the highest share price have the greatest weight. While this may have been appropriate in the Dow’s early days, it makes no sense now.

The S&P 500 and most other indexes, in contrast, are weighted by the stocks’ market capitalization. So PF Growth Portfolio holding Apple (NSDQ: AAPL) or ExxonMobil (NYSE: XOM), for example, account for much more of the index’s performance than Hormel Foods (NYSE: HRL), say.

The three stocks now being dropped from the Dow are low-priced issues (particularly Alcoa and Bank of America) that together make up only 3 percent of the total average.

The addition of Visa, recently trading at $185, and Goldman Sachs ($163) will give those two stocks disproportionate influence in the Dow. They’ll rank second and third, just behind IBM ($190).

Five stocks will account for one-third of index: IBM, Visa, Goldman Sachs, Growth holding Chevron (NYSE: CVX) and 3M (NYSE: MMM). Four large companies—Pfizer (NYSE: ! PFE), Gro! wth holdings Cisco Systems (NSDQ: CSCO) and Intel (NSDQ: INTC), and GE—will have a combined weighting of about 5 percent, or less than Goldman Sachs alone. Goldman, with a market value of $75 billion, will carry about five times the weight of Microsoft (NSDQ: MSFT), which has a $270 billion market cap.

Adding to the oddity, the Dow holds only one of the four biggest public companies by market cap in the US: ExxonMobil. The other three are #1: Apple, #3: Google (NSDQ: GOOG) and #4: Berkshire Hathaway (NYSE: BRK-A, NYSE: BRK-B).

Under the current methodology, the inclusion of Google (trading at $892) and Apple ($470) would completely distort the index. Berkshire Hathaway, with its voting stock at $170,000 and the other one at $113, would also present challenges.

Silly, isn’t it?