Examining Changes to the Dow 30 Components

Every few years investors hear of impending changes to the Dow Jones Average, the broad index of 30 industrial stocks created by Charles Dow in 1897, widely used as a stock market barometer. For the majority of the 20th century, changes to the index’s components were rare. Only when one of the 30 stocks was acquired by another company would they be replaced, and the new addition would usually be in the same industry as its predecessor.

However, with the bull market of the 1990’s, Dow Jones & Company (DJ), the publisher of the index, began changing the group of 30 stocks even without any news of a merger. With stock prices rising at a rapid pace, cheerleaders for stock ownership were everywhere. Dow Jones & Company figured it could boost stock prices even more by replacing underperforming companies with better ones.

Rather than saying they wanted to boost the Dow’s performance, those who orchestrated the changes justified such actions be claiming that the new index “better represented the country’s ever-changing economy.” Basically, even though we still filled up our cars’ gas tanks at Chevron stations and wrote on paper made by International Paper, these companies really weren’t good gauges of the so-called “new economy.” With the advent of the digital camera, somehow Kodak no longer deserved to be in the Dow, despite billions of dollars in annual sales and owner of one of the country’s more prominent brands.

Were these changes really necessary? I was never a big fan of them. Companies go through ups and downs. Businesses are cyclical. When oil prices are low, companies like Chevron won’t make very much money and their stock prices won’t perform very well. Does that mean we should boot them from the Dow? Probably not. Nonetheless, since 1999 exactly 7 of the Dow’s 30 stocks have been replaced due to economical irrelevency (read “bad stock performance”).

Not being a big proponent of bandwagons as far as stocks are concerned, I am truly excited to have discovered yet another contrarian indicator for stocks. Think about it. Dow Jones boots a poorly performing stock and adds an elite name to the index. Isn’t this the perfect contrarian indicator for someone who loves buying out-of-favor stocks? After all, if you get booted from the Dow, your company must really be down in the dumps. And if you are the lucky company to be named a replacement, you really must have done well lately.

So, the next time a change is made to the Dow Jones Industrial Average, I will be trading on the news. I’ll short the stock that gets added and pair that trade with the purchase of the company that got the axe. Will this strategy work, you ask? Well, let’s take a closer look at how the aforementioned 7 alterations since 1999 have fared after the changes took effect.

On November 1, 1999, four stocks were removed from the Dow; Chevron (CVX), Goodyear Tire (GT), Sears (S), and Union Carbide (UK). Not surprisingly, they were replaced by some bull market high-fliers; Home Depot (HD), Intel (INTC), Microsoft (MSFT), and SBC Communications (SBC).

Less than five years later, in April 2004, more changes were announced. This time 3 companies were replaced. American International Group (AIG), Pfizer (PFE), Verizon (VZ) took over for AT&T (T), Eastman Kodak (EK), and International Paper (IP).

Dow Jones & Company, as well as most investors, were probably thrilled with the decision to replace these “old economy” stocks with newer, faster growing market darlings. The great news (if you’re looking for contrarian investment opportunities) is that the performances of the two groups of stocks has been quite a dichotomy, just not in the way many would have expected.

Of the 7 stocks deleted from the Dow since 1999, 3 of them were either acquired or are in the process of being acquired (Dow Chemical bought Union Carbide, Sears is going to be bought by Kmart, and AT&T is going to be purchased by fellow Dow member SBC Communications). All told, on average, the seven deleted stocks have risen by a staggering 227% since their removal. That equates to a return of more than 32% each.

While those returns are impressive, they won’t make for much of a contrarian investment strategy unless the ones that replaced them gained less than 32% on average. Amazingly, the 7 stocks added to the Dow haven’t gone up at all. In fact, they’ve lost a combined 155% since they were added to the index, for a loss of 22% each. Only one of the seven has risen in price (Verizon) and its shares are up a meager 2%.

Hopefully more changes to the Dow are coming, for contrarian investors’ sake anyway.

A Pair of Growth Stock Ideas for ’05

The majority of investments found in Peridot-run portfolios could be classified as either contrarian plays or undiscovered value stocks. Nonetheless, sometimes there are growth companies out there that look so attractive that even Peridot will be more than willing to “pay up” for them and watch their businesses grow like wild fires over the course of several years.

While forking over 30 times earnings for stocks is rare for us, in recent weeks we have been accumulating shares of small-cap restaurant chain Buffalo Wild Wings (BWLD) and mid-cap clothing retailer Urban Outfitters (URBN). In both cases, the tremendous growth potential over the next three to five years gives us comfort, even though the high multiples of these names make the stocks very volatile.

From a p/e-to-growth rate (PEG) perspective, you can make the case that 30x 2005 estimates is not too high, given that both companies are slated to grow 25 percent a year, for a PEG ratio only 1.2, compared with 2.0 for the S&P 500. If both BWLD and URBN are able to maintain their growth, which we believe they can, there is no reason both stocks cannot hold above-market multiples for years to come. In fact, both of these stock could triple in the next five years, for a compound annual growth rate of more than 20 percent.

The main reasoning for these growth assumptions is the combination of an extremely popular concept, in addition to a relatively small store base in place at the current point in time. Customers are raving about both Buffalo Wild Wings restaurants and all three concepts that Urban Outfitters is rolling out (Urban Outfitters, Anthropologie, and Free People). BWLD owns and operates 290 units, with ab0ut a third of them in the state of Ohio alone. The company sees the potential for at least 1,000 restaurants in the U.S. URBN still only has 71 Urban stores and 62 Anthropologie stores, or fewer than 1.5 of each per state.

As both of these companies continue to grow, in both popularity and sheer size, both stocks should reflect such growth, making them excellent stories to hold for many years to come.