Why The Dow Jones Should Be 20,000 Points Higher

You know how everyone in the investment community loves to rag on IBM stock? Well, there’s nothing new about that. In fact, this lament might be something you have in common with your grandfather.

When part of President Roosevelt’s New Deal legislation included the Social Security Act of 1935, Wall Street got excited by the lucrative contract that IBM secured to process social security checks upon the program’s inception in January 1937.

Unfortunately for IBM shareholders, the contract contained a provision that demanded IBM perform the government services at cost if more than 3% of social security payments were made in error during the first year. By January of 1938, the independent congressional inquiry found that 4.7% of social security payments were not processed correctly.

As a result, IBM stock fell almost 20%. This wasn’t merely the result of IBM’s lack of profit regarding social security check processing, but rather, a forward-looking expectation that FDR would seek to punish IBM for embarrassing him.

With hindsight, we know this sentiment was overblown.

However, in March of 1939, the Dow Jones Committee decided to remove IBM stock and replace it with AT&T.

This remained the case until IBM re-entered the Dow Jones Index in 1979 by replacing Chrysler.

It is not hyperbole to suggest that this marked the greatest index selection mistake in the history of American finance.

Between 1939 and 1979, IBM had the best performance out of any company on the entire New York Stock Exchange. It compounded at a rate of 21.48%. Every now and then, you will see newspapers track down people that have held Berkshire Hathaway for forty years and built a wildly enormous passive fortune. What they really ought to do is track down the long-term holders of IBM stock during post-war America. It had 125 million shares outstanding. Some people out there had to own ‘em all. A mere $1,000 grew into $41 million during this four-decade time period in which IBM was excluded from the index.

Meanwhile, the replacement AT&T did fine and delivered 8% annual returns. It performed according to expectations, and granted shareholders nice lifestyle upgrades during this time, but it unfortunately looks bad in comparison because it replaced literally the best publicly traded stock in America.

As a result, the Dow Jones only grew from 150 to 850 over the time period in which IBM was excluded. If IBM had remained the whole time? The Dow Jones would have crushed through the 20,000 barrier in 1975. By the time IBM re-entered the index in 1979, it would have raised the value to 23,500.

Because I know about things like this, you can understand a little bit better why I don’t follow the mindless endorsement of index funds that seems to be in vogue these days. Of the people I know who have received large inheritances and contacted me about it, all but one of them received bonds and equities held through index funds (and the one exception received 100 shares of Apple when it was trading at $700+ per share in addition to S&P 500 based index fund investments). It seems a bit to me like parents hoarding their kids’ baseball cards in the 1990s because they knew what great value the thrown-away cards of the 1950s and 1960s would later possess. Of course, they don’t realize that when all of their upper class peers adopt the same behavior, you end up with an index valued at 25x earnings and set to deliver subpar 6% annual returns because no one pays attention to the mechanics of what drives returns anymore.

Also, you can understand why my investment articles don’t freak out about IBM as much as everybody else. If any publicly held business gets to adopt Virgil’s line in the Aeneid of “Through various chances, through all vicissitudes, we make our way” as their official motto, it’s gotta be IBM. It always goes through periods of extreme un-fashionability followed by catch-up years when people realize that owning a stake in an $11 billion profit engine can be fun. Heck, it has paid out $14.75 per share in dividends over the past three years while everyone has been grumbling about it.

Is there a silver lining to all of this? Well, yes. Index funds didn’t exist in 1975, and the first Dow Jones index fund didn’t get created until 1977. And there wasn’t even $1 billion in capital indexed to the Dow Jones until 1992. So it’s not like there was some class of investors that was distinguishably harmed by IBM’s exclusion. However, to the extent that the then-existing Dow Jones holdings informed the security selection of professionals and lay investors, IBM’s exclusion may represent squandered wealth. Any “scandal” here is limited by the fact that those 125 million IBM shares still had somebody owning them during that forty-year time slot, and those people were compounding wealth faster than Warren Buffett himself in his prime.

So anyway. Everyone these days is talking about the Dow Jones hitting 20,000, but I think the real story is that it could have easily happened forty years ago.

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