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Why Does the Dow Change the Stocks it Tracks?

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On March 19, 2015, the Dow Jones Industrial Average changed for the 54th time in 130 years. The DJIA (or Dow) is one of the most popular measurements of stock market and economic activity, even though it's changed more often than you might think.

The companies in the Dow are 30 enormous American corporations. Its value is the weighted average of the stocks in the Dow. A weighted average is this: for every $1 change in price of any stock in the Dow index, the Dow itself changes by 6.42 points.)

When the Dow changes the companies it tracks—as it does every few years—it does so in an attempt to reflect the behavior of the American economy and the stock market more effectively. What's the true state of American business? Which industries are growing? Which are shrinking? Which companies are truly the core of American corporate business? When the Dow member companies change, pay attention.

Why Did the Dow Add Apple?

Apple is one of the great technological turnaround stories of the 21st century. When its cofounder Steve Jobs returned, he oversaw the company's transformation into a niche computer manufacturer to a consumer electronics and media powerhouse. With the iPod, iTunes, iPhone, and iPad (as well as the continued success of its Mac lines), Apple became one of the richest companies in the world. Sometimes it's the largest company in the world in terms of market capitalization.

As the largest company in the world, Apple is a great fit for the Dow. Though the DJIA is well established (and seen as stodgy in some circles), keeping up with the times—reflecting how important consumer mobile devices are to the modern world—represents how the index attempts to reinvigorate itself.

It doesn't hurt that Apple had a stock split not long before the addition; that kept is stock price of over $700 from dominating the rest of the index.

Why Did the Dow Drop AT&T?

AT&T was one of the lowest-priced stocks in the index. It was also seen as redundant in the telecommunications sector. The Dow's inclusion of Verizon already gave enough weight to that sector.

At least, that's the line of reasoning that anyone willing to go on record gave. In likelihood, the combination of Apple's stock split, the doldrums of AT&T's stock price, and the relative cachet of the two companies made the decision easy.

Why Did the Dow Drop Hewlett-Packard?

Hewlett-Packard was one of the original Silicon Valley success stories. Its founders built a high technology equipment company from humble roots in a garage into a globe-spanning company in diverse technology areas.

HP has struggled in the 2000s. A fissure in its board of directors has culminated in a steady stream of troubled CEOs. The company isn't sure where it's going or what it's doing, and its stock price has reflected that. The Dow replaced HP with Visa.

Why Did the Dow Drop Alcoa?

Unless you follow the aluminum market, you may have never have heard of Alcoa. When manufacturing and heavy industry dominated the American market, the raw materials sector (things like steel and, in Alcoa's case, aluminum) was a powerhouse. Alcoa's stock rode high, soaring to huge valuations.

That hasn't been the case for a long time, and Alcoa's valuation was tiny (between $8 and $9 billion dollars) compared to other stocks. As of December 2014, Alcoa rose to healthy $18-20 billion valuation, but that was long after its replacement by Nike. At that point, Nike had a valuation of almost $60 billion—seven or eight times larger.

Why Did the Dow Drop Bank of America?

Dropping Bank of America in favor of Goldman Sachs doesn't make much sense, when you compare market capitalization. Bank of America had twice the capitalization of Goldman Sachs—over $150 billion compared to about $75 billion.

Keep in mind that the Dow tracks the absolute dollar values of stock prices alone, without weighting the size of the company (market capitalization), earnings, or anything else. In that sense, it wants companies with higher stock prices even though they're not necessarily better. Bank of America's stock price of $15 in late 2013 looked worse than Goldman Sachs with a stock price of $160 per share.

Why Did the Dow Add Nike?

Nike's huge and growing. Alcoa isn't. The aluminum industry has been on the decline as a share of American business for a long time. It's surprising Alcoa has been in the Dow as long as it has.

Why Did the Dow Add Visa?

The Dow classifies Visa as an information technology company, just like HP. (Seriously, the Dow Jones reorganization press release says so). Swapping one industry leader for another makes a lot of sense, especially when one appears to be ascending and the other declining.

More than that, HP's being penalized for its lost decade and a half. The company hasn't gone anywhere since the disastrous days of Carly Fiorina (think of all of the acquisitions that haven't turned out at all well), and there's little hope for a dramatic turnaround. Visa, on the other hand, is like many other companies in the financial services industry: making lots and lots of money.

Why Did the Dow Add Goldman Sachs?

No one can explain this. Goldman Sachs specializes in investment banking—high end services. Bank of America has a much broader focus that includes consumer banking. This swap may be solely based on share price, which is a silly measurement anyhow. (See The Dow Jones Industrial Average is Ridiculous for more details.)

Should Investors Care About Changes to the Stocks in the DJIA?

The Dow Jones Industrial Average is just a measurement. It doesn't change the worth of its member companies. It may give a temporary boost to some share prices (Goldman Sachs, Nike, Visa) and penalize others (Alcoa, Bank of America, Hewlett-Packard), but that's short-lived.

Further, changes in the DJIA over its lifespan—not just changes to the stocks tracked but the weighting multiplier of the index itself—make the index difficult to analyze over the long term. Sure, the fact that the Dow hit 18,000 points in late 2014 seems like an interesting figure, but it's an impressive and round number based not on market capitalization but on stock prices divorced from things like the P/E Ratio or dividend yield suggest that the measurement is arbitrary and artificial.

It represents something, but does it represent something worth acting on? This is one persistent and strong criticism of the DJIA. It's scorekeeping without intrinsic meaning.

What's still important—and what hasn't changed—is that the long term value of a company still depends on how much money it can generate for its owners. The presence or absence of a stock in any index is irrelevant to the quality of the business. Buy good companies. That's how to build wealth by investing.