The Dow changed its composition in November of last year, replacing four vintage companies with newer ones offering higher growth. The stocks of the newcomers have outperformed those of the outcasts since then. The previous Dow makeover, in 1997, also resulted in four substitutions. Again the newcomers easily outperformed their outcast brethren. Although Foolish Four investors may have taken a recent hit with the departure of Sears and Goodyear, in the long run we're much better off without outcasts like these.
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Recall that in early November of last year, four seasoned Dow companies were replaced with adolescent upstarts. The arthritic veterans Chevron <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: CHV)") else Response.Write("(NYSE: CHV)") end if %>, Union Carbide <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: UK)") else Response.Write("(NYSE: UK)") end if %>, Sears <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: S)") else Response.Write("(NYSE: S)") end if %>, and Goodyear Tire <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: GT)") else Response.Write("(NYSE: GT)") end if %> were ousted by flashy superstars Intel <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: INTC)") else Response.Write("(Nasdaq: INTC)") end if %>, Microsoft <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: MSFT)") else Response.Write("(Nasdaq: MSFT)") end if %>, SBC Communications <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: SBC)") else Response.Write("(NYSE: SBC)") end if %>, and Home Depot <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: HD)") else Response.Write("(NYSE: HD)") end if %>. These newcomers, representing the best and the brightest of the "new economy," were expected to jump start an ailing Dow, whose returns had fallen behind the S&P 500 and the Nasdaq in recent years.
Dow newcomer Intel dropped 22% on Friday in the face of earnings warnings. The plunge reminded me of an observation made by Michael O'Higgins, recounted in Beating the Dow. In 1991, O'Higgins commented that almost invariably the stocks that were replaced in the Dow in the previous 12 years outperformed the newcomers. O'Higgins really didn't mention any specifics. I thought it would be instructive to check just how the recent Dow outcasts have performed, both in comparison to the newcomers that displaced them and to market indexes.
The most recent Dow shuffle impacted some Foolish Four investors dramatically, because two of the companies, Sears and Goodyear, were anchoring many a F4 portfolio at the time. These companies were floundering then. If the Dow hadn't changed horses, they'd likely be candidates for inclusion on the annual portfolio renewal date. The Dow changing of the guard locked in the losses for many F4 investors.
Here's how the recent Dow outcasts have performed since the changeover. The following are the total returns, including dividends, from November 1, 1999 until the close of the markets Monday:
Outcasts Return (%)
Chevron -6.5
Goodyear -53.0
Sears +21.2
Union Carbide -37.8
Newcomers Return (%)
Home Depot +8.6
Intel +17.3
Microsoft -33.8
SBC Comm. -6.5
1999 Outcasts -19.0%
1999 Newcomers -3.6%
S&P 500 +6.3%
DJIA +0.7%
As a group, our four newcomers outperformed the outcasts by over 15%; both groups underperformed the S&P 500 and the Dow. Foolish Four outcasts Sears and Goodyear went in opposite directions since the ousting, with the former being the clear winner.
We'll score last year's change in the Dow composition as a qualified success for the index. But let's go back just a little further, to track the performance of the outcasts in the previous Dow makeover. In March of 1997, the Dow jettisoned another four stocks, again four crusty old Dow veterans. Bethlehem Steel <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BS)") else Response.Write("(NYSE: BS)") end if %>, Texaco <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: TX)") else Response.Write("(NYSE: TX)") end if %>, Westinghouse Electric, and Woolworth were booted from the Dow team, replaced by newcomers Hewlett-Packard <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: HWP)") else Response.Write("(NYSE: HWP)") end if %>, Johnson & Johnson <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: JNJ)") else Response.Write("(NYSE: JNJ)") end if %>, Travelers Group, and Wal-Mart <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: WMT)") else Response.Write("(NYSE: WMT)") end if %>.
A few of these companies have undergone significant corporate restructuring since 1997. Westinghouse changed its name to CBS, then merged with Viacom <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: VIA)") else Response.Write("(NYSE: VIA)") end if %>. Woolworth changed its venerable name to Venator <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: Z)") else Response.Write("(NYSE: Z)") end if %>. Travelers merged with Citicorp to become Citigroup <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: C)") else Response.Write("(NYSE: C)") end if %>. With a little bit of digging, we calculated the returns that a shareholder would have received had they held the original stocks through thick and thin.
Here are the total returns, from March 7, 1997 through Monday:
Outcasts Return (%)
Bethlehem Steel -62.3
Texaco +8.2
Westinghouse +210.1
Woolworth -39.6
Newcomers Return (%)
Hewlett-Packard +71.2
Johnson & Johnson +69.8
Travelers +203.2
Wal-Mart +267.0
1997 Outcasts +29.1%
1997 Newcomers +152.8%
S&P 500 +89.9%
DJIA +55.6%
It's pretty clear that the 1997 Dow newcomers are again trouncing the outcasts, this time by a very large margin. The 1997 outcasts are woefully lagging behind the market indexes, while the newcomers are way ahead.
There's little doubt the Dow newcomers have left the outcasts in the dust -- at least for the last two Dow makeovers. The complexity of the Dow formula makes it a Herculean task to calculate "what-if" Dow value scenarios. Just eyeballing the numbers, it seems like a pretty good bet that, without the two most recent changes, today the Dow would be under the psychological milestone 10,000. Change is good, at least where the Dow is concerned. Although Foolish Four investors may have taken a recent hit with the departure of Sears and Goodyear, in the long run we're much better off without outcasts like these.
Next week we'll look at some more Dow substitutions, going back to the 1970s. We'll also explore how one might exploit such observations to create strategies that have the potential to trounce the Dow and require even less maintenance than the Foolish Four.
Beating the S&P year-to-date returns (as of 09-26-00):
Bank One <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: ONE)") else Response.Write("(NYSE: ONE)") end if %> +15.2%
PepsiCo <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: PEP)") else Response.Write("(NYSE: PEP)") end if %> +27.2%
Ford Motor Co. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: F)") else Response.Write("(NYSE: F)") end if %> -13.7%*
Bank of America <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BAC)") else Response.Write("(NYSE: BAC)") end if %> +10.2%
Fannie Mae <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: FNM)") else Response.Write("(NYSE: FNM)") end if %> +10.0%
Beating the S&P +9.8%
Standard & Poor's 500 Index -2.9%
*Includes Visteon <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: VC)") else Response.Write("(NYSE: VC)") end if %> spin-off
Compound Annual Growth Rate from 1-2-87:
Beating the S&P +23.8%
S&P 500 +16.7%
$10,000 invested on 1-2-87 now equals:
Beating the S&P $184,300
S&P 500 $83,000