Is It Time for a Change in the Dow?

Let's face it: The Dow Jones Industrial Average isn't perfect. It's prone to following trends to its own detriment, as occurred most notably near the peak of the dot-com bubble. Its price-weighting calculation gives disproportionate influence to companies with triple-digit share prices, and it also effectively bars some notably expensive stocks from ever joining. A rather tiny roster of only 30 different stocks makes it a bit limited as a representation of the American economy.

And yet we watch it every day. Over the long run, the Dow has actually performed better than the S&P 500, largely as a result of its superior resistance to the dot-com crash:

^DJI Chart
^DJI Chart

^DJI data by YCharts.

Some of that is certainly due to timely component changes. Just as the Dow will occasionally fumble a new addition, some swaps turn out to be gems. A number of the Dow's standouts joined during the period shown on this chart, including one which was removed in 2008 despite more than doubling the Dow's performance during its tenure:

^DJI Chart
^DJI Chart

^DJI data by YCharts.

However, there have been plenty of ill-timed additions as well, especially since that dot-com debacle:

^DJI Chart
^DJI Chart

^DJI data by YCharts.

On balance, the Dow's doing all right, but it's certainly not perfect. A few choices that have built its present roster are downright head-scratching. Do we really need five technology stocks yet no automakers? Should the Dow highlight three pharmaceutical companies (and one health insurer), but only one true retailer? The Dow, "industrial" or not, is no longer a representation of the biggest manufacturers in the country; it's a representation of industry, in the broadest sense of the word. In that sense, its components should more accurately reflect the economy. So which companies should get the boot, and which should be part of the Dow's next generation?


In: Ford

The Dow hasn't had an automaker on its roster since General Motors went bankrupt in 2009, but that industry is still just as important to the American economy as it was before the controversial bailouts. We've yet to see anyone talk about bailing out the PC industry, but at the rate things are going, HP might need one: Its revenue is essentially flat for the past five years, but earnings per share have fallen off of a cliff .

In the same time period, Ford's revenue may have dipped by roughly 14%, but its EPS is now near the highest levels since the dot-com era. That can't continue forever, of course, but Ford is a larger company by both revenue and earnings than HP, and as the last American automaker left standing -- i.e., the one that has never gone bankrupt -- it's the logical choice to fill the void left by GM's departure. However, its share price is a bit lower than HP's, which means we might need to make another change to maintain some balance in the Dow's price weighting...

Out: Alcoa

In: FedEx

Alcoa is no longer the bellwether it once was. It's been surpassed by two foreign miners in terms of production, and it lags far behind the largest miners in terms of size (if not profitability, as the whole sector has been in a slump of late). FedEx, however, is one of today's most watched economic bellwethers, and its share price would make it the Dow's second triple-digit stock, providing a nice counterweight to IBM while also readjusting the index's weightings more strongly in favor of the retail side of our tech-heavy economy.

Not only is FedEx twice Alcoa's size by revenue, but it's also growing in importance while the aluminum producer shrinks, with revenue up 15% in the past five years compared to a drop of nearly 20% in Alcoa's top line. Mining and smelting have become increasingly globalized in scope, but package delivery remains a national business, and FedEx's results can often give us a better indication of the economy's direction than the results of a company dependent on publicly traded commodity prices.

Out: Merck

In: CVS Caremark

This one might be a little controversial. Health care is still tremendously important to the American economy, but focusing on individual drugmakers can miss the forest for the trees. Merck is still quite the profitable drugmaker, but it's only the third-largest on the Dow by either revenue or net income, and it's less diversified than fellow component Johnson & Johnson.

To better represent health care in the United States, why not highlight the country's largest pharmacy chain? Not only is CVS the largest pharmacy chain, but it's also the nation's second-largest retailer by revenue -- and with only one retailer on its roster, the Dow isn't exactly representing that sector in relation to its importance to the economy. In the process, the Dow would kill two birds with one stone. Health care would be more broadly accounted for, and retail would rise in importance as well. Merck is susceptible to the ups and downs of drug patent life cycles, but CVS' revenue relies more on the American consumer's ability and willingness to pay for prescription drugs.

What do you think? Do these replacements make sense, or are there better swaps available for the Dow? Let me know what you think with a comment.

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Fool contributor Alex Planes holds no financial position in any company mentioned here. Add him on Google+ or follow him on Twitter @TMFBiggles for more insight into markets, history, and technology.The Motley Fool recommends FedEx, Ford, General Motors, and Johnson & Johnson. The Motley Fool owns shares of Ford, International Business Machines., and Johnson & Johnson. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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