Because of the coincidence that I wrote an article about AT&T’s merger with DirecTV on the eve of the Dow Jones announcement that Apple would be replacing AT&T in the Dow Jones Index, I received quite a few e-mails from readers asking whether that kind of move should be treated as a signal that Apple should be purchased or AT&T should be sold. I did not get a chance to respond to any of those readers, but hopefully my discussions here will provide an adequate answer to the question.
First, the Dow Jones Index has little rational bearing on actual buy-and-hold decisions these days, despite the fact that it is widely circulated in the news. If you turn on the TV at 10 o’clock and watch the news, it is likely that the reporters will give you both the results of the S&P 500 and the Dow Jones from that day. Hearing them mentioned side by side all the time can lead to thinking in terms of a false equivalency—the S&P 500 Index actually affects the short-term flow of money in many 401(k)s throughout the land, whereas the Dow Jones Index only results in 1/40 of the money flow that a change in the composition of the S&P 500 will bring about.
The reason why someone doesn’t get a job, start a 401(k), and then find a Dow Jones Index into which to throw their retirement dollars is because mutual fund providers are reluctant to create price-weighted indexes. This sounds a little wonkish, but the point is this: The Dow Jones is weighted by the price of the stock so that Visa at $270 per share will have 7x the influence that AT&T (which is still part of the index) will have at $35 per share. This bothers rational participants in the market because you are judging a company partially based on how many ownership pieces of the company exist. Visa is cut up into 600 million pieces, and AT&T is cut up into 5.2 billion pieces. This fact is utterly inconsequential for making investment decisions—it is reminiscent of Yogi Berra’s adage that he’d rather have a pizza cut into four pieces because he doesn’t feel like he could eat eight.
The much more rational approach of the S&P 500 is to weight companies based on overall size, rather than take into consideration how many pieces they cut themselves into—AT&T is a $173 billion company and Visa is a $165 billion company, and therefore, should have nearly equal influence on the index. This rationality is why index funds are structured to follow the S&P 500 rather the Dow Jones—both Visa and AT&T are equal size, and the fact that Visa is broken up into about 1/7th as many pieces should not be the basis for determining influence.
I am not saying that the S&P 500’s approach is perfect-when a stock gets expensive it becomes a larger part of the index and when it gets cheap it becomes a smaller part of the index under market cap-weight formulas, but it is much more rational than price weighting.
Secondly, the exodus from the Dow Jones does not imply poor results ahead. From 1957 through 2003, companies that got removed from an index actually outperformed stocks that got added to the index by almost two percentage points. Jeremy Siegel theorizes this is due to the fact that companies leaving the index have low expectations and therefore can outperform the easy hurdle of low expectations whereas the new entrant has higher expectations and can more easily underperform those lofty goals. I am not saying that general trend applies to Apple’s addition to the index, but am providing a theory about the general rule.
To use recent examples, Altria returned 150% since getting kicked out of the index, Honeywell is up 80% since getting kicked out of the index, and Citigroup is up 50%. It’s not an omen of poor things to come.
Thirdly, the best response to these types of events is to independently study the company and recognize that companies will perform in line with fundamentals over the long-term. If AT&T acquires DirecTV and grows profits at 5% annually, it will give investors a 5.5% dividend that ought to account for total returns of around 11% over that coming five year period if you get higher than expected growth, a bit of P/E expansion, and mix in the substantial dividend. If the company grows profits at 2%, you will likely look at total returns around 8%. The point is that the performance of the company over the coming years is what will determine an investor’s total returns, not whether it is a part of a particular index (and the practical significance of the Dow Jones is much less than the S&P 500).
In short, I view the inclusion or exclusion of a company from an index as a fact of short-term significance at best and utter irrelevance at worst. The data doesn’t support the general rule that exclusion harms company performance, and even then, the more important rule that a company’s subsequent performance determines results would still be controlling. Whether you decide to buy, sell, or hold Apple or AT&T should be based on your study of those company’s business prospects, not their placement in a particular index.