Changing of the Guard: Dow Update
Mark is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
On Sept. 24 there will be a new member of the venerable Dow Jones Industrial Average (.DJA). That also means that one company will be removed from the index. The 30 stocks that comprise the Dow are supposedly representative of U.S. industrial and overall economic activity although many are not manufacturers. It marks the first change since 2009.
The keeper of the index, S&P Dow Jones Indices, is making the changes for two basic reasons:
1. Kraft is in the process of spinning off its grocery business. It will have much lower revenues generated within the U.S. and therefore won't be as much of a barometer of economic activity and market direction.
2. UnitedHealth is part of one of the fastest growing segments of the overall economy, healthcare.
UnitedHealth generated earnings growth of about 10% a year over the last five years and is projected to continue that in the future. The valuation looks good too with a P/E ratio of about 11, slightly higher than the 5-year average of 9 and lower than the industry average of 19. It has generated free cash flow of $4 billion to $5 billion each year over the last few years. The balance sheet looks decent with a debt/equity ratio under 50%. A caveat is how the new health care law, scheduled to take full affect in 2014, will impact the company.
There has been a lot of discussion recently about companies like Apple, Inc. (NASDAQ: AAPL) or Google (NASDAQ: GOOG) and whether or not they should be part of the Dow because of their importance to the American economy. However, the argument against inclusion is that, because the Dow is price-weighted, stocks with large share valuations may unfairly skew the index towards them which may not be representative of the rest of the market and economy. Recent share prices for both Apple and Google were over three times that of the largest weighted stock currently in the index.
The Dow and the S&P 500 indices have tracked each other fairly well over the last 10 years. See the chart below.
UnitedHealth, although outperforming the S&P 500 by about a third and the Dow by over 80%, has for the most part mirrored the overall market except for a period in 2005 and 2006. Kraft has not followed the market.
One measure of a stock's record of tracking the market is the relative volatility or beta. It has primarily been used as a gauge of risk. Values less than the S&P 500 index beta of 1.0 indicate less risk than a stock with a number greater than 1.0. UnitedHealth has a beta fairly close to the benchmark at 0.89. Kraft is much less volatile (therefore less in line with the index) at 0.50.
Are Apple and Google representative of the overall market? Apple certainly is not as it has moved out of step with the Dow, the S&P 500 and Google. It has a beta 21% higher than the index. Google has a beta of 1.07, much closer to the benchmark value.
Are they indicative of the overall technology industry as represented by the NASDAQ Composite (^IXIC)? Google is a much better indicator than Apple.
So I think the S&P Dow Jones Indices made good choices in putting UnitedHealth in the Dow and kicking Kraft out. It also looks like not adding Apple was a wise decision too. Although it has been a great stock, it may not be a good representative of the overall market and economy. One of my fellow Foolish bloggers suggested that Apple should even be its own index. I think he hit the nail on the head. I'm looking forward to buying the Apple Index.
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Mathman6577 owns shares of Apple. The Motley Fool owns shares of Apple and Google. Motley Fool newsletter services recommend Apple, Google, and UnitedHealth Group. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.