An Averages Committee periodically changes the stocks in the Dow. Sometimes, this is because a firm’s stock is no longer traded after it merges with another company or is taken over by another company. Other times, a company has some tough years and is no longer considered to be a blue chip stock. Such fallen companies are replaced by more successful companies.
For example, Home Depot replaced Sears on November 1, 1999. Sears is a legendary American success story, having evolved from a mail order catalog selling everything from watches and toys to automobiles and ready-to-assemble houses into the nation’s largest retailer. Sears had been in the Dow for 75 years, but now was struggling to compete with discount retailers like Walmart, Target, and, yes, Home Depot. Revenue and profits were falling, and Sears’ stock price had dropped nearly 50 percent in the previous six months. Home Depot, on the other hand, was booming along with home building and remodeling, and was opening a new store every 56 hours. Its tools competed directly with Sears’ legendary Craftsman tools and it seemed to be winning this sales battle. Home Depot’s stock price had risen 50 percent in the past six months.
When a faltering company is replaced by a flourishing company, which stock do you think does better subsequently—the stock going into the Dow or the stock going out? If you take into account regression to the mean, the stock booted out of the Dow probably will do better than the stock that replaces it.
This is counterintuitive because it is tempting to confuse a great company with a great stock. LeanMean may be a great company with a long history of strong, stable profits. But is it a good investment? The answer depends on the stock’s price. Is it an attractive investment at $10 a share? $100? $1,000? There are some prices at which the stock is too expensive. There are prices at which the stock is cheap. No matter how good the company, we need to know the stock’s price before deciding whether it is an attractive investment.
The same is true of crummy companies. Suppose that Polyester Suits is on a downward death spiral. Polyester currently pays a dividend of $1 a share, but expects its dividend to decline steadily by 5 percent a year. Who would buy such a loser stock? If the price is right, who wouldn’t? Would you pay $5 for a $1 dividend, then 95 cents, then 90 cents, and so on? If the $5 price doesn’t persuade you, how about $1? How about 10 cents?
Let’s go back to the Dow additions and deletions. The question for investors is not whether the companies going into the Dow are currently more successful than the companies they are replacing, but which stocks are better investments. The stocks going into and out of the Dow are all familiar companies that are closely watched by thousands of investors. In 1999, investors were well aware of the fact that Home Depot was doing great and Sears was doing poorly,. Their stock prices surely reflected this knowledge. That’s why Home Depot’s stock was up 50 percent, while Sears was down 50 percent.
However, regression to the mean suggests that the companies taken out of the Dow are generally not in as dire straits as their recent performance suggests and that the companies replacing them are typically not as stellar as they appear. If so, stock prices will often be unreasonably low for the stocks going out and undeservedly high for the stocks going in. When a company that was doing poorly regresses to the mean, its stock price will rise; when a company that was doing well regresses to the mean, its price will fall. This argument suggests that stocks deleted from the Dow will generally outperform the stocks added to the Dow.
Sears was bought by Kmart in 2005, five and a half years after it was kicked out of the Dow by Home Depot. If you bought Sears stock just after it was deleted from the Dow, your total return until its acquisition by Kmart would have been 103 percent. Over the same five-and-a-half year period, an investment in Home Depot, the stock that replaced Sears, would have lost 22 percent. The Standard & Poor’s 500 Index of stock prices during this period had a return of -14 percent. Sears had an above-average return after it left the Dow, while Home Depot had a below-average return after it entered the Dow. (The Kmart-Sears combination has been ugly, but that’s another story.)
Is this comparison of Sears and Home Depot an isolated incident or part of a systematic pattern of Dow deletions outperforming Dow additions? There were actually four substitutions made in 1999. Home Depot, Microsoft, Intel, and SBC replaced Sears, Goodyear Tire, Union Carbide, and Chevron. Home Depot, Microsoft, Intel, and SBC are all great companies, but all four stocks did poorly over the next decade.
Suppose that on the day the four substitutions were made, November 1, 1999, you had invested $2,500 in each of the four stocks added to the Dow, a total investment of $10,000. This is your Addition Portfolio. You also formed a Deletion Portfolio by investing $2,500 in each of the stocks deleted from the Dow.
Table 1 shows how these portfolios did compared to the S&P 500 during the decade following the substitutions. After ten years, the S&P 500 was down 23 percent. The Addition Portfolio did even worse, down 34 percent. The Deletion Portfolio, in contrast, was up 64 percent.
Still, these are just the four Dow substitutions made in 1999. Maybe, 1999 was an unusual year and substitutions made in other years turned out differently? Nope. A 2006 study of all 50 changes in the Dow back to October 1, 1928, when the Dow 30-stock average began, found that deleted stocks did better than the stocks that replaced them in 32 cases and did worse in 18 cases. A portfolio of deleted stocks beat a portfolio of added stocks by about 4 percent a year, which is huge difference compounded over 78 years. A $100 portfolio of added stocks would have grown to $160,000 by 2006; a $100 portfolio of deleted stocks would have grown to $3.3 million.
The Dow Dogs, companies doing so poorly that they are booted out of the Dow have been better investments than the darlings that replace them.