NEW YORK – The barometer of America’s stock market – the Dow Jones industrial average – is getting a makeover.
Alcoa, Bank of America and Hewlett-Packard are being dropped from the index of America’s 30 top companies and replaced by Goldman Sachs, Nike and Visa.
It’s the index’s biggest change in almost a decade. Dow will make the switches, which take effect Sept. 23, because of the falling stock prices of the removed companies and a need to more accurately represent the economy.
Here is how the Dow works and what the changes mean:
Q: What is the Dow?
A: It’s the most popular gauge of the health of the stock market and U.S. economy. It was created in 1896 by Charles H. Dow, one of the founders of the Wall Street Journal, with the intention of giving the stock market credibility and making investing more understandable. The original index had 12 members. The number of companies making up the Dow gradually increased to 30 in 1928.
The index is calculated and published by S&P Dow Jones Indices, a joint venture owned by McGraw-Hill, CME Group and Dow Jones. A small committee decides which companies are added to or dropped from the Dow.
Q: Who gets in the Dow?
A: It’s an elite club. The Dow’s members are often referred to as blue-chip stocks, and entry into the index is reserved for a company that “has an excellent reputation, demonstrates sustained growth and is of interest to a large number of investors.”
Because the Dow has only 30 members, compared with the 500 members of the Standard & Poor’s 500 index, entry is limited. The committee that decides which stocks join the Dow tries to pick companies that best represent the makeup of the economy.
Q: Why are Bank of America, Hewlett-Packard and Alcoa being removed?
A: Low stock prices are the primary reason for their removal, along with a need to better represent the makeup of the economy.
The Dow is a price-weighted average, which means that the higher the stock price, the more influence the stock has over the index’s level. Bank of America, HP and Alcoa were the lowest-priced stocks in the Dow, so their movements did not affect the index as much as higher-priced members.
Alcoa, Bank of America and HP are still quality companies and remain in the S&P 500, which is a broader gauge of the stock market.
Q: Why were Goldman Sachs and Visa added?
A: Goldman Sachs replaces Bank of America, so the Dow is swapping one financial company for another. It’s a little different with the Visa-HP trade. While most people think of Visa as a financial company because of its credit and debit cards, Visa is actually a giant technology company focused on payment processing. Replacing HP with Visa is, in a way, a replacement of one tech firm with another.
Q: Google and Apple are huge companies. Why didn’t they get picked?
A: Google and Apple are too expensive to be in the Dow. Google’s stock trades at nearly $900, and Apple shares are around $500, several times more expensive than the Dow’s priciest members.
Every change of $1 in any of the 30 Dow stocks moves the index by the same number of points, roughly 7. That gives more sway to companies with higher stock prices. And it’s easier for a $100 stock to rise $1 than it is for a $10 stock.
Apple and Google would have too much weight in the Dow. The $23 stock price of Intel, a hugely influential technology company valued at $115 billion, would not move the Dow as much as a $900 share of Google, which is worth $295 billion.
It’s the same reason why Warren E. Buffett’s Berkshire Hathaway, probably one of the most diversified conglomerates in the U.S., is not in the Dow. Berkshire “A”’ shares trade at $170,000.
This price weighting is one of the Dow’s biggest flaws, according to investors. The index’s entire formula would need to be restructured to admit high-priced stocks such as Apple, Google or Berkshire.
Q: Does the Dow’s makeup change often?
Not usually. The last change to the Dow’s membership happened in September 2012, when Kraft Foods was removed and replaced with UnitedHealth. Kraft was pulled because it was breaking into two companies.
The index underwent a quick succession of changes during the financial crisis, however. Citigroup, General Motors and American International Group, or AIG, were all members at one point. AIG was removed in 2008 when it imploded and required a government rescue. GM, at the time one of the longest-serving members of the Dow, was stripped of its Dow membership when it filed for bankruptcy in 2009. Citigroup was also removed because of the problems it faced during the financial crisis.
The last time three members of the Dow were replaced at the same time was 2004, when AT&T, Eastman Kodak and International Paper were replaced by AIG, Pfizer and Verizon Communications.
Q: How have Dow members done after being added?
A: Since UnitedHealth replaced Kraft, the stock is up 33 percent, more than twice as much as the S&P 500. In June 2009, Travelers Cos. replaced Citigroup, and Cisco replaced GM. Since then, Travelers is up by more than 100 percent, compared with the 90 percent rise in the S&P 500. Cisco is up by 31 percent