The Dow Revisited

            Long ago and far away, when this guru we know was managing pension funds at Fallutin National, performance was measured against the Dow Jones Industrial Average (The Dow).  If prospective clients could be wowed with stats showing that Fallutin wise guys consistently beat The Dow, quarter in and quarter out, the bank’s acclaimed Fiduciary Investment Division got the account.  If not, Fallutin generally reeled in their business anyway, as there’s a way to play this implied threat that Fallutin studs know inside stuff other studs don’t, and play it Fallutin did.  This slick-haired capo they’d roll out for such performances plucked that one like a string virtuoso.

            Well, string-along virtuoso was more like it really.

            Now, The Dow is a price-weighted average, meaning quants just add up the closing market quotes for its 30 components and apply this thing called a divisor to adjust for prior stock splits and whatnot, and come up with that day’s number.  The dividends those companies pay out aren’t included anywhere in the calculation.

            And so, if a performance-oriented financial thug maintained a portfolio doing the exact same price-weighted thing, but reinvested those dividends, he’d outperform The Dow by the amount of the dividends less management fees.  Consistently, quarter after quarter.   Over time, that outperformance compounded, becoming considerable, and Slick could pull out these 50 year projections that bedazzled.

            (Note that today’s index funds aren’t the same thing if they pass dividends along to fundholders).

            But there was another way to beat The Dow too.  Hire stock pickers.  All a Crime Family stock picker had to do was hold your better performing Dow components in his portfolios, deep six the rest of the Dow stocks, and then add a few choice winners from outside the average, and this way was more fun, and almost everybody did that, and nobody at Fullutin who did that ever made it work, and the results were mostly mortifying, and the one guy who price-weighted the Dow into his portfolios gave numbers to Slick, and Slick prospected with a “representative” portfolio from price-weight guy, and price-weight guy became very unpopular with everybody else at Fallutin because he was a winner and they were all losers, almost every single one, and he got disgusted and quit, and a sadness fell upon One Fallutin National Plaza that reached all the way down from the senior executive suites on the 800^th Floor, or wherever the senior executives were perched atop that lofty skyscraper of theirs.

            History aside, there are several good reasons for holding Dow stocks.  In bad economic times, these titans eat their competition alive.  Titan stock prices get drubbed too, but Dow giants come out of every catastrophe bloated with delicious new assets, licking their chops over the all-new playing field because they’re way, way stronger on it than ever before.  Ok, there are more reasons, but that’s always been enough for long term investors like, well, everybody who’s managed to hold onto their capital over the past four or five decades, including our enlightened MacDougal Post subscribers.

           The Dow is disrespected by people who've never assembled a universe of investment grade "industrial" stocks that 1) they'd want to invest in, and 2) survive rigorous analysis.  Those 30 names, well most of them anyway, and maybe 50 more are pretty much it for us.  Beyond that, you encounter folks adding clients to their lists, and worse.  Indices like the S&P 500 introduce risks that render them useless for traditional conservative market participants.  Many of their components simply do not live through a worst case scenario test.  We live in a world of short-term public traders weirdly viewing stocks as a commodity.  Maybe such products are suitable for them.

            We've used an investment grade universe index from time to time, and found no reason to substitute it for The Dow.  That average is an outstanding proxy for the entire group of companies we'd consider investing in as its a very, very exclusive club.

            And so, from time to time we like to revisit The Dow, take a quick peek, and see what’s what up in there.  Last week’s switcheroo, UnitedHealth for Kraft, announced amid the Ben Bananas QE3 oil stocks and friends rally, struck us as one of those times, and we figured we’d share it with you.

            Using traditional baskets, the 2 oil stocks in The Dow account for 12% of the average, 7 industrials, 24%, 5 tech stocks, 17%, and 4 financials, 10%.  Together, these are traded as cyclicals, with financials generally getting smacked down the hardest in your routine catastrophic stock market crash, and the cyclical sector presently comprises 67% of The Dow.  With the addition of UnitedHealth as of September 24, there will be 4 medical stocks in the average, accounting for 11% of it, leaving 8 Dow stocks classified as consumer non-durables to make up the remaining 26%.  The last two industry groups have always been deemed defensive, and together now represent 37% of the average.

            Wall Street Crime Families trade off these definitions, jacking up cyclicals while bashing defensive issues, for example, so it’s helpful to know this kind of stuff sometimes.  Like last week, for starters.  The new risk on, risk off caper became cyclicals on, defensives off as soon as Ben went publicly bananas with his QE3 blabberings.

            The Dow’s total market capitalization (cap) is currently a bit over $4 trillion.  A company’s market cap equals total common shares outstanding times the market price, and the grand total is all of them added up.  Exxon, at $462 billion, is the largest component, accounting for something over 11% of the grand total, and the seven biggest companies, as measured by market cap, also including Microsoft, Wal-Mart, IBM, GE, Chevron, and A T & T, comprise 50% of it.

            Alcoa, reeling from competition by breakthrough 21^st Century materials, is the smallest company here.  At $11 billion, it’s market cap is only .3% of the total, and the bottom nine companies, also including Travelers, Hewlett Packard, Dupont, Boeing, UnitedHealth, Caterpillar, 3M, and American Express, going from smaller to larger, each account for less than 2% of the grand total.

            Bank of America sits in the middle of the pack with a market cap of $103 billion.  On the balance sheet, its shareholder’s equity has been reported at, or close to, $230 billion the last three years.  If its stock price returned to the 2008 high, the bank’s market cap would top the list, just elbowing out Exxon for that coveted Number One slot.

            Whatever, it strikes us that price action in those two oil stocks, Exxon and Chevron, will reflect how professional money managers are positioning themselves for QE3.  What’s going on with these issues, others in the oil patch, and stocks of any company owning or processing any commodity/raw material, for that matter, drew a lot of bullish interest the last time we faced Consumer Price Index Hell and survived to tell the tale.

            Not that we’re stock pickers, mind you.  No way to go, that madness.  Unless you're wired into the mob, of course.

            In the 70’s, stocks outside the commodity/raw materials sectors did not fare well while inflation raged.  Such companies would end up weeks or months behind with their books, matching sales with the wrong costs in the wake of relentless price hikes, and it devastated their reported numbers even though the businesses remained sound and other, more appropriate, ways of accounting for rising prices would not have printed troubling results.  To value investors, this looked like a huge opportunity to buy iconic stocks.

            And it was.  Value stocks came out big winners during the end game.  As inflationary pressure waned, value outperformed inflationary momentum favorites big time.  Who knows?  Maybe history will repeat itself this go-around.  Or maybe modern automated inventory systems will beat the inflationary lag, and companies will now be reporting more accurate quarterly results.

            Lastly, at 207, IBM makes up 12% of The Dow, it and Chevron, 18%, and those two plus 3M, Caterpillar, Exxon, and McDonald’s, almost 40%.  If a performance stud is not similarly weighted in these six stocks, his chances of keeping up with the average in the event that those stocks lead it upward are slim to none, but, on the other hand, all he has to do to blow away the competition is guess correctly on moves right here, and this same kind of thinking has to be applied to any Dow stock that gets hot or cold, which is why professionals obsess over these issues and you see so much written about Dow components everywhere you look.

            In the 70’s, long-term bondholders lost maybe two-thirds of their purchasing power, and oil stocks ruled.  Money market funds, if you reinvested the interest, preserved your capital.  Money market investors who spent that interest fared no better than victims of those catastrophic long-term bonds.  Our guru went into that decade with a single piece of advice from a survivor of the Weimar Republic debacle:  hold industrial assets, including iconic common stocks.   You’ll get knocked around bad for a while, he strangely advised, but take the beating.  They’ll hold their value in the end.  Gold and whatever did not work out as nobody had any idea what anything was worth, what Crime Family gumbas need to hear to turn trading into a zero odds proposition for everyone else in that hopelessly rigged game of theirs.