The Dow's Biggest Mistake in 2013

The Dow Jones Industrials have hit new record highs on 50 separate occasions during 2013, and its gain of better than 25% ranks it among the best annual returns in recent decades. Yet the Dow could have had even better performance had it simply avoided one simple mistake: replacing Alcoa , Hewlett-Packard , and Bank of America back in September.

AA Total Return Price Chart

Dow component Total Return Price data by YCharts

The history of former Dow stocks
Even before the Dow had announced its planned replacement of B of A, HP, and Alcoa, many had already examined the question of how stocks that had recently gotten kicked out of the Dow had fared. In some cases, stocks had fallen so far before they exited the Dow that they had no realistic chance of ever recovering. Yet often, stocks that left the Dow because of poor performance found ways to bounce back and make up lost ground.

That's largely what has happened with two of the three stocks that left the Dow in September. For Hewlett-Packard, the long-range turnaround efforts that CEO Meg Whitman spearheaded have been slow to bear fruit, but shareholders have remained stubbornly on board. Even after posting strong gains in 2013 before getting the Dow boot, HP has climbed another 33% since. The tech giant is far from done with its transformation, with its most recent quarterly results still including sizable drops in revenue and net income. But favorable factors like climbing sales in its enterprise division point toward potential success in the long run, even though newly private rival Dell and other big-tech competitors will inevitably fight to hold HP back from making any further progress.

Aluminum giant Alcoa has also dramatically outperformed the Dow, soaring 29% since late September. The aluminum industry still faces plenty of hurdles in making a full recovery, with supply gluts still putting pressure on prices and making profits hard to come by. But Alcoa's efforts to rein in supply by shutting down unprofitable production facilities have started to put a floor under aluminum prices. Moreover, a recent $110 million supply deal with Airbus is just a small example of the potential that the aluminum giant has in supplying the rapidly growing aerospace industry with critical lightweight components that help drive demand for the newest aircraft models from major producers.

Making it 3-for-3
Finally, Bank of America hasn't gained as much as its two former Dow peers, but its 8% rise still outpaces the Dow. The second-largest bank in the country by assets has had to pay tens of billions of dollars in lawsuit and regulatory settlements, but it's also focusing on improving its operational success. Initiatives to encourage more cross-selling across its banking, credit cards, mortgage loans, and wealth management businesses has resulted in more high-value referrals, encouraging greater customer retention. B of A still has further to climb before it can declare final victory over the financial crisis, with its dividend stubbornly unchanged at a penny per share. Still, Bank of America appears still to be on the path to recovery, and shareholders have rewarded the company handsomely in recent years.

Given the low share prices all three of these components had, even their outsized gains wouldn't have had a huge impact on the Dow's returns. But nevertheless, it's telling that all three managed to beat the Dow, once again showing that just because the Dow gets rid of stocks doesn't mean that they're doomed to failure.

Does the Dow have the right banking stocks?
Having gotten rid of B of A, the Dow still has some bank stocks among its ranks. But are they the right ones? The sector has one notable stand-out, and in a sea of mismanaged and dangerous peers, it rises above as "The Only Big Bank Built to Last." You can uncover the top pick that Warren Buffett loves in The Motley Fool's new report. It's free, so click here to access it now.

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Fool contributor Dan Caplinger owns warrants on Bank of America. You can follow him on Twitter: @DanCaplinger. The Motley Fool recommends and owns shares of Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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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