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Earlier this week, the index committee of S&P Dow Jones Indices decided to remove key companies from the Dow Jones Industrial Average. Bank of America Corporation (BAC - Analyst Report), Hewlett-Packard Company (HPQ - Analyst Report) and Alcoa Inc. (AA - Analyst Report) will exit the index at the end of trading on September 20, when the decision comes into effect.

These stocks will be replaced by The Goldman Sachs Group, Inc. (GS - Analyst Report), Nike Inc. (NKE - Analyst Report) and Visa Inc. (V - Analyst Report) which will feature on the index in their place when trading starts on September 23. This is the most significant such move since April 2004. On that occasion, AT&T, Inc. (T - Analyst Report), Eastman Kodak and International Paper Company (IP - Analyst Report) had exited the index. They were replaced by American International Group, Inc. (AIG - Analyst Report), Pfizer Inc. (PFE - Analyst Report) and Verizon Communications Inc. (VZ - Analyst Report).

The Rationale Behind the Changes

The reason for the changes was outlined clearly by David Blitzer, managing director and chairman off the index committee. The Dow is a price-weighted barometer. This means that the higher the price of a company on the index, the larger its weight. This is significantly different from indices which weight their components on the basis of market capitalisation, such as the S&P 500.

The companies being removed are amongst the lowest in the index on the basis of price. They continue to be important multinational corporations, but their stock prices has fallen to an extent that they contribute to only 3% of the total average, according to Blitzer. Such changes were, therefore, inevitable considering the rationale on which the index is based.  

The Fortunes of Those Making an Exit

Alcoa

With prices ranging between $7 to 8 per share, Alcoa is easiest amongst the lowest priced among those being removed. Most importantly, the U.S. economy has moved away from being dependent on heavy manufacturing towards sectors such as technology, finance and healthcare.

The company will remain largely unaffected by the Dow’s decision. But it will affect the image and prestige of a corporation, struggling to combat wildly fluctuating prices by focussing on value added sales to the automotive and aerospace sectors.

Bank of America

The fact of the matter is that the aluminium producer never recovered from the recession of 2008. The case is more or less similar for Bank of America. Since then, it has been trying to reduce the size of its business. It has also been dealing with a large number of legal problems arising from its purchase of Countrywide Financial in 2008.

Even though the share price of this stock is still below the levels it achieved before the crisis, it has trended upwards last month. Last year, the share price had doubled. In this case as well, there will be no financial impact from this decision. But the bank is a long way from achieving the success it did before the crisis.

HP

This was the second computer firm to be added to the index in 1997, after IBM Corp. (IBM - Analyst Report). At this point it is facing various business challenges, even though its stock price has increased by more than 50% this year.  One example of its problems is the enormous write-down it had to make last year after its unfortunate purchase of British software firm Autonomy.

The more disastrous acquisition, that of Compaq, occurred even earlier. This purchase meant that the company continued to focus on PCs while the world moved on to smartphones and tablets. Even in its chosen domain, it has little proprietary technology of its own.

The Impact on the Index

Even though it is only a thirty stock index, the Dow is still considered to be an important barometer of the economy. The idea behind the changes seems to be an attempt to make the index more representative of the financial markets as a whole.

The Dow has been criticized for being a price weighted index, but that is another matter altogether. The major issue weighing on it for some time now was that it was being heavily dominated by some stocks, primarily IBM, priced at $185 a share and making up 9.43% of the index.

The components being removed have an average share price of $15. On the other hand, those being added are priced at an average of $134.50 a share. Goldman Sachs, Visa and Nike will now make up 17.4% of the index.

The excessive dominance of IBM on the index is why these inductions have been made, says Blitzer. This is also why the likes of Apple and Google have been left out. Blitzer feels they would bring in even larger distortions due to their share prices.

Ultimately, the Dow’s decision has been one of the signature events for financial markets this year. Many may question the Dow’s rationale for such decisions. But ultimately it remains a significant barometer for the economy. Any move to make it more representative is, therefore, a welcome one.

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