Why does the Dow change stocks it tracks?

Why Does the Dow Change the Stocks it Tracks?

On September 23, 2013, the Dow Jones Industrial Average changed for the 53rd time in 128 years. The DJIA (or Dow) is one of the most popular measurements of stock market and economic activity, even though it's changed more often than you might think.

The Dow tracks the prices of 30 large American corporations and the value of the Dow represents a weighted average of those stock prices.

When the Dow changes the companies it tracks—as it does every few years—it does so in an attempt to reflect the behavior of the American economy and the stock market more effectively. What's the true state of American business? Which industries are growing? Which are shrinking? Which companies are truly the core of American corporate business? When the Dow member companies change, pay attention.

Why Did the Dow Drop Hewlett-Packard?

Hewlett-Packard was one of the original Silicon Valley success stories. Its founders built a high technology equipment company from humble roots in a garage into a globe-spanning company in diverse technology areas.

HP has struggled in the past several years, with a fight on the board of directors which has culminated in a steady stream of troubled CEOs. The company isn't sure where it's going or what it's doing, and its stock price has reflected that. The Dow is replacing HP with Visa.

Why Did the Dow Drop Alcoa?

Unless you follow the aluminum market, you may have never have heard of Alcoa. When manufacturing and heavy industry dominated the American market, the raw materials sector (things like steel and, in Alcoa's case, aluminum) was a powerhouse. Alcoa's stock rode high, soaring to huge valuations.

That hasn't been the case for a long time, and Alcoa's valuation is tiny (between $8 and $9 billion dollars) compared to other stocks. Nike, its replacement, has a market capitalization of almost $60 billion.

Why Did the Dow Drop Bank of America?

Dropping Bank of America in favor of Goldman Sachs doesn't make much sense, when you compare market capitalization. Bank of America has twice the capitalization of Goldman Sachs—over $150 billion compared to about $75 billion.

Keep in mind that the Dow tracks the absolute dollar values of stock prices alone, without weighting the size of the company (market capitalization), earnings, or anything else. In that sense, it wants companies with higher stock prices companies even though they're not necessarily better. Bank of America's stock price of $15 or so looks worse than Goldman Sachs with a stock price of over $160 per share. (However, you're probably better off owning Nike over the long term than Alcoa.)

Why Did the Dow Add Nike?

Nike's huge and growing. Alcoa isn't. The aluminum industry has been on the decline as a share of American business for a long time. It's surprising Alcoa has been in the Dow as long as it has.

Why Did the Dow Add Visa?

The Dow classifies Visa as an information technology company, just like HP. (Seriously, the Dow Jones reorganization press release says so). Swapping one industry leader for another makes a lot of sense.

More than that, HP's being penalized for its lost decade and a half. The company hasn't gone anywhere since the disastrous days of Carly Fiorina (think of all of the acquisitions that haven't turned out at all well), and there's little hope for a dramatic turnaround. Visa, on the other hand, is like many other companies in the financial services industry: making lots and lots of money.

Why Did the Dow Add Goldman Sachs?

No one can explain this. Goldman Sachs specializes in investment banking—high end services. Bank of America has a much broader focus that includes consumer banking. This swap may be solely based on share price, which is a silly measurement anyhow. (See The Dow Jones Industrial Average is Ridiculous for more details.)

Should Value Investors Care about the Dow Jones Changes?

Keep in mind that the Dow Jones Industrial Average is just a measurement. It doesn't change the worth of its member companies. It may give a temporary boost to some share prices (Goldman Sachs, Nike, Visa) and penalize others (Alcoa, Bank of America, Hewlett-Packard), but that's short-lived.

What's still important—and what hasn't changed—is that the long term value of a company still depends on how much money it can generate for its owners. The presence or absence of a stock in any index is irrelevant to the running of the business. Focus on that and buy good companies.