With such a riveting headline, you’re probably a little skeptical of how much time you want to dedicate to this blog post…
We all take for granted, to some degree, that the indexes that represent the stock market are, in fact, the stock market. When someone asks how the market performed over a certain period, we typically quote the S&P 500, or the Dow Jones Industrial Average if the need arises. But is it fair to assume that the Dow or the S&P are the market? The short answer is not really, though it’s close enough for most purposes.
So why are they flawed? First of all, the S&P 500, while broadly diversified with 500 stocks, still only includes one segment of the market: U.S. large-cap stocks. Not mid-caps, not small-caps, not international stocks. And obviously not privately-held businesses. Still, U.S. large-cap is a large segment of the market. There are broader indices, like the Wilshire 5000, which includes nearly every publicly-traded U.S. stock. Among global indices, the MSCI ACWI Index includes 2,300 stocks from around the world, comprising 85% of global market cap. Here’s your index trivia question of the day: how many U.S. stocks are among the largest 20 holdings in the ACWI? Answer at the end.
Let’s just say if there was a nascent movement for the ACWI to supplant the S&P or the Dow as the index of choice for Joe Six Pack, we haven’t heard about it. MSCI apparently hasn’t put a strong effort into marketing. But if you want to start the movement, by all means, just be sure you know how to pronounce it: ack – wee.
Now, as for the Dow, we will never be pushing anyone to make the Dow a benchmark for two reasons: it has only 30 companies and it is price-weighted. That means that the higher the stock’s price, the bigger weighting in the index. It doesn’t matter whatsoever the market capitalization, assets, revenues, or earnings of the companies. So when one of the Dow constituents splits its stock, the stock’s weighting drops commensurately, even if nothing else changes about the company. UnitedHealth is now 9.5% of the Dow. Apple is 3%. If not for its 4-for-1 stock split and 7-for-1 split, Apple would be over half of the Dow. So why does the Dow hold such a prominent place among armchair investors, and even the financial media? Longevity and tradition. Like a good recipe, it seems we just pass down the Dow addiction from generation to generation.
You might really question this tradition when we fill you in on a couple things that surfaced in the financial news this week. First, we were reminded that on August 31, 2020, the Dow replaced 3 standing members with 3 new ones. Dow Jones does this from time to time, mostly to try to “stay relevant” with “the times.”
Exxon Mobil, one of two energy behemoths in the Dow (along with Chevron) was replaced by Salesforce, the cloud software behemoth. Recall that, in 2020, oil prices went negative for a brief time, but even in August, oil was still really cheap, and “peak oil” demand was declared to have come and gone. Software was hot, particularly cloud software, in the covid lockdown era.
Pfizer, just two months before it announced the success of its covid vaccine, was replaced in the Dow by Amgen. This was something of a head-scratcher, given that Pfizer has twice the market cap of Amgen and they’re in the same industry. It was probably a nod to the fact that Amgen is technically a “biotech” whereas Pfizer is just “pharma,” even though the distinction is fairly immaterial in reality. Dow Jones likely caught wind of the fact that a lot of biotech startups with no commercial products were coming public and shooting the moon, because that’s the type of stock that did well in 2020. Amgen perhaps was seen as the most investable of a hot trend.
The final Dow new entrant was Honeywell, which replaced Raytheon Technologies. Recall that Raytheon was the largest of the 3 spinoffs from United Technologies, which broke up in March, 2020 (Carrier and Otis are the other two). Honeywell has been a great business and great stock for a long time, and we would buy it in the rear-view mirror portfolio. That said, the need for this change between companies in the same industry (aerospace) is also wanting. The two companies have roughly the same market cap, and Raytheon has double the revenues.
These moves were somewhat galling since we widely owned all 3 rejected stocks at Monarch. Rather than kick them to the curb, like the Dow, we continued to find value in them. Here’s how the 6 stocks have performed since the 8/31/20 Dow realignment, through yesterday:
Imagine if you had a hedge fund built around buying stocks that get kicked out of the Dow and then shorting the new entrants to the Dow. You’d have made a killing, at least this time. It makes us wonder how common this is…we remember Eastman Kodak and Sears were in the Dow not all that long ago.
Also resurfacing this week was a story of how the Dow Industrials had admitted IBM in 1932, but booted it in 1939. In 1939, Dow Jones changed the methodology of the Dow Jones Utility Average to hold only power utilities, not communications utilities. So AT&T (aka “Ma Bell”) was removed from the Utility Average and, because it was such a big company, was then added to the Dow Industrials, replacing a much smaller IBM. By 1979, Dow Jones realized IBM was doing well, so it was added back after a 40-year hiatus. You can probably guess the result. AT&T stock wasn’t terrible between 1939 and 1979; it rose 149% (granted, that’s only a 2% annual gain). But IBM’s stock rose 21,941%.
Between 1939 and 1979, the Dow rose from 151 to 841. But if IBM had remained instead, the Dow would have risen to 23,582 in 1979, not 841. Kind of a big difference. Note that this assumes that IBM would not have split its stock, owing to the quirky Dow calculation construct.
Is there a moral in the story, or was this all for your (and our) amusement? Probably more the latter. Just know that in the long term, your stocks will perform based on the fundamentals of the companies, not based on their weighting in an index. Also, it is nice to see contrarianism get rewarded, when you do the opposite of what the crowd does. One takeaway for us is that we might have to start memorizing the values of the ACWI in case someone asks us how it’s doing.
Trivia answer: 18 of the 20 largest company weightings in the ACWI (and thus market caps) are U.S. companies. The only international stocks that crack the top 20 are Taiwan Semiconductor at #10 and Nestle at #18. Saudi Aramco would rank #1 except that only 1.5% of its shares float publicly.