Understanding The Dow: Are New Inclusions Good For Long-Term Investors?
On September 10 we learned of major changes to the components of the Dow Jones, but will these changes have any impact on the performance of the index?
The Dow Jones: A price-weighted index
While the Dow Jones might be the most recognized of the three major U.S. indexes, it has the least regard for the actual valuation of its components. The index is determined by the price of its components, not market capitalization.
Therefore, Caterpillar is weighed heavier than Bank of America, despite Bank of America's market cap being three times greater. Thus, in many ways, the Dow Jones' performance can be misleading to economic performance, yet is crucial to market psychology.
Major changes taking place
IBM, with a stock price over $185, is weighed heaviest on the Dow Jones at 9.4% of the total index . Bank of America, Hewlett-Packard, and Alcoa, combined, make up just 2.29% of the index, as all are priced below $23. However, these somewhat meaningless stocks to the Dow Jones are being removed, and replaced with Visa , Goldman Sachs , and Nike .
Clearly, you notice a big price difference between the new and old Dow components. Visa (at $185), Goldman (at $165), and Nike (at $67) will all be heavily weighted in the index. In fact, Visa and Goldman should be the second and third most important stocks to the Dow Jones.
A shift in weight
While the Dow Jones has performed well in 2013, adding a gain of nearly 16%, the performance at the top has been surprisingly mediocre.
2013 Stock Performance
For the most part, it has been the mid-weighted components such as Johnson & Johnson, Disney, Home Depot, and JPMorgan that have pushed the index higher with year-to-date gains greater than 20%, which are all massive companies. Now, the index is adding three companies that have been top market performers, which will be crucial to the future trend of the Dow Jones.
Hence, if the Dow Jones is going to trade higher over the next year, then new inclusions Visa, Nike, and Goldman will have to perform well. Because with these three new companies, the weight of top performing mid-weight stocks will decline.
For example, If Visa and Goldman are numbers two and three, respectively, by weight on the Dow Jones, then both will account for more than 6.23% of the total index, which is the weight of current No. 2 Chevron. If we assume that new inclusions account for 15% of the Dow, and only 2.3% of its weight was replaced, then mid-weighted stocks will also lose their importance to the index.
What will be the outcome?
Looking ahead, the most important question becomes whether or not Visa, Goldman, and Nike can trade higher long-term.
In the last five years, Visa has traded higher by over 155% as global debit and credit spending has accelerated, especially in emerging markets. But despite $11.5 billion in annual revenue, and a large piece of the payment processing market, there are a few concerns.
For one, how will Visa weather the storm of new payment systems from the technology industry's elite? ebay already has PayPal, but reportedly, Facebook, Google, and Apple are all prepping to introduce similar services. If so, how does this hinder Visa's growth?
At 22 times earnings, Visa is already significantly more expensive than the Dow Jones, which trades at 15.7 times earnings , and with mobile spending expected to double in the next three years, it appears that Visa has serious competition looming.
Goldman Sachs has been a leader in the financial space, and at 10 times earnings it is cheaper than the Dow Jones. However, despite the company's 30% revenue growth, Goldman is an extremely cyclical stock that is 45% more volatile than the overall market, with a beta of 1.45. Thus, to be weighed so heavily, its volatility must be a concern in a market where the investor's psyche is fragile at best.
Lastly, it's hard to say anything negative at all about the retail giant Nike, who has produced breathtaking growth and has returned mind-boggling gains over the last five years. But at 25 times earnings, is the stock getting a little pricey? Also, with retail spending showing signs of decline, is Nike a bright star in a dull sky or is it a fire that is about to burn out?
As an investor, you have to like the Dow Jones' thought process to eliminate the weakest links of the index for big name top performing companies. However, uncertainty and lingering questions have to make you wonder if maybe the Dow has missed the boat on the companies that it included.
Just to be clear, these new inclusions could all trade significantly higher in the immediate future, but at some point valuation must be considered. Some might argue that Nike and Goldman are both good gauges of economic growth and health, but because of the questions raised, and their weight on this very important index, the Dow Jones might have become a more risky index for long-term investors.
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The article Understanding The Dow: Are New Inclusions Good For Long-Term Investors? originally appeared on Fool.com.Brian Nichols has no position in any stocks mentioned. The Motley Fool recommends Goldman Sachs, Nike, and Visa. The Motley Fool owns shares of Nike and Visa. 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.