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An Index is Not Forever: Changes in the DowSubmitted by Townsend Asset Management Corp. on June 26th, 2018
The venerable Dow Jones Industrial Average (DJIA) is the second-oldest U.S. market index after the Dow Jones Transportation Average. It was created in 1896 by Charles Dow, the editor of the Wall Street Journal and co-founder of Dow Jones & Co. Initially, the DJIA had just 12 companies, but was expanded to eventually include 30 companies.
General Electric (GE) was the last remaining company of the original 12 Dow components. The others have long since been acquired, merged, or gone out of business. The components of the DJIA have changed 51 times since the inception of the index. And since 1999, 17 stocks have joined the DJIA, while 17 others were pushed out. GE is being replaced in the DJIA by Walgreens Boots Alliance (WRA).
The DJIA is an odd index, as it is “price-weighted” vs. the more common “market-capitalization-weighted” indexes, such as the S&P 500. Why is that odd? Assume you have two different companies, who are each valued at $1 million (that is their “market capitalization”). Suppose Company A issues 1 million shares of stock to investors while Company B only issues 100,000 shares of stock. The price per share for Company A will be $1 ($1,000,000 market capitalization / 1,000,000 shares), while the price per share for Company B will be $10 ($1,000,000 market capitalization / 100,000 shares). So, the price per share is drastically different just because of a decision about how many shares to issue.
If both of these companies were included in the DJIA “price-weighted” index, Company B will be weighted at ten times the weight of Company A, owing to its $10 price vs. the $1 price of Company A.
But aren’t the two companies worth exactly the same amount? Why should B’s weighting be ten times higher than A? Because that is what you get with a price-weighted index.
Despite its anachronistic structure, the DJIA remains the most-watched index in the world. However, due to is price-weighting mechanism, it is difficult for the DJIA to include stocks such as Google’s parent Alphabet (GOOGL) and Amazon (AMZN) because of their high ($1,000+) stock prices.
Interestingly, according to Ned Davis Research, going back to 1972, stocks that have been removed from the DJIA have tended to outperform it over time, with companies outpacing the blue-chip index by an average of 9.2% over the following 12 months. Perhaps this is because for companies leaving the DJIA, most of the bad news is already reflected in their share price. GE shares are hovering near lows not seen since the financial crisis. Contrast this with stocks who are being added to the DJIA. Their stock prices are often at near-term highs – although Walgreen’s shares are just modestly higher than their 52-week lows.
The changes in the DJIA components is a reminder that indexes are not forever. They change over time to reflect the dynamism and creative-destruction of our economy.
Gerald A. Townsend, CPA/PFS/ABV, CFP®, CFA®, CMT is president of Townsend Asset Management Corp., a registered investment advisory firm located in Raleigh, North Carolina. Email: Gerald@AssetMgr.com