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Lessons for Equity Investors From Dow Jones' Big Shake-Up

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In the largest reshuffle of the Dow Jones Industrial Average since 2013, ExxonMobil (XOM - Free Report) , Pfizer (PFE - Free Report) and Raytheon Technologies (RTX - Free Report) were removed from the storied 30-stock index yesterday. Notwithstanding their exclusion, these companies remain blue-chip, global entities, apart from being behemoths in their own sectors.

The three newcomers are customer relationship management software provider salesforce.com (CRM - Free Report) , biotech firm Amgen (AMGN - Free Report) and conglomerate Honeywell International (HON - Free Report) . The index changes were prompted by the low stock price of the three companies booted out and Apple's 4-for-1 stock split.

Pharmaceutical giant Pfizer joined the index in 2004, while Raytheon’s tryst with the equity gauge was for a mere five months following the aerospace and defense company’s merger with United Technologies. But the thing that stands out is the exclusion of ExxonMobil, which had joined one of the world’s most recognizable index in 1928.

Difference Between Other Indices and the Dow Jones

Most indexes — including S&P 500 — use market capitalization (value or size) as the basis for a company’s inclusion or exclusion at a particular point. In other words, the ranking is not dependent on share price alone but share price times number of shares outstanding. On that basis, the three companies leaving the index remain pretty big players, albeit being fallen angels. In fact, Pfizer, ExxonMobil, and Raytheon are ranked 25th, 33rd and 70th on the S&P Index.

Meanwhile, the Dow Jones is a rare example of an index constructed on the basis of a component's share price. In fact, it is an average, and the higher a constituent's price, the greater the impact it has on the index. In this context, the other remaining members of the Dow have a much higher price than the ones deleted — for example Home Depot ($285.04), UnitedHealth Group ($312.55) and Visa ($211.99). In comparison, shares for Pfizer, ExxonMobil and Raytheon traded for $37.79, $39.94 and $61, respectively, yesterday.

As such, Pfizer, ExxonMobil and Raytheon’s market capitalization of $211 billion, $172 billion and $95 billion are irrelevant even though they exceed Caterpillar’s $78 billion and American Express’ $83 billion — both still members of the Dow.

Does the Jettisoning Matter?

To professional investors, funds and institutions, it doesn’t matter a great deal as they usually do not follow Dow Jones owing to its somewhat peculiar mechanism of weighting stocks by price, rather than market value. So, ExxonMobil reacted by dropping just 3.2%, while Pfizer and Raytheon shares lost a tad more than 1% — small stock price movements for such a high-profile event. It is because only a fraction of money tracks the Dow stock market index compared to the S&P 500, which is regarded as one of the finest reflections of the stock market as a whole.

But for retail investors (like us), a lot of attention is attached to the Dow Jones Industrial Average thanks to its wide publicity and media coverage. The danger is that investors attach excessive emphasis on an index that is somewhat outdated, relatively small and weighted on a basis that seems obsolete for this day and age. Consequently, they can be drawn into doing something impulsive like selling shares of a company just because it has slipped out of the top 30 companies in the Dow.

Conclusion

Truth be told, Pfizer, ExxonMobil and Raytheon are not the powerhouses they used to be and have fared poorly of late. The three stocks leaving the index are beset by problems. In particular, ExxonMobil’s departure reflects the dwindling clout of the energy sector in the American economy.

The oil biggie is down more than 40% year to date, while Raytheon has tumbled 35% in the same period. Pfizer did much better, with the stock dipping less than 4% since Jan 1. Meanwhile, the index has lost a mere 0.4% over a similar timeframe.

Specifically, ExxonMobil’s fall from grace has been spectacular. The world’s most-valuable publicly traded company even in 2011, the oil and gas supermajor was already struggling with bloated capital spending and poor returns when the coronavirus-induced energy market collapse put the final nail in the coffin.

Industrial powerhouse Raytheon has been bogged down by the United Technologies merger, continued disruption in air travel and rising costs of raw materials like steel. Lastly, Pfizer investors seem to be worried over the patent expiration faced by several products in the drug maker’s portfolio over the next few years.

On the other hand, investors should know that some of these companies have not fallen below its peer group members in value terms. For example, ExxonMobil is ahead of Dow’s only energy stock Chevron (CVX - Free Report) . As it is, basing an index on share prices alone seems arbitrary. Therefore, investors are advised not to use the Dow Jones as a yardstick for stock related decisions, despite the brand clout that it commands.

ExxonMobil, Pfizer and Raytheon currently carry a Zacks Rank #3 (Hold).

You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

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