Thursday, September 12, 2013

Ins and Outs: Icahn Withdraws, Spitzer Loses, and the DJIA Reconstitutes

Ins and Outs: Icahn Withdraws, Spitzer Loses, and the DJIA Reconstitutes

This has been a week of ins and outs.  Carl Icahn and Southeast Asset Management withdrew their offer to acquire Dell, removing the last impediment to Michael Dell’s purchase of the troubled computer manufacturer.  After eight months, the deal is finally going to be completed with Mr. Dell and his co-investors paying a bit more than they had originally proposed.[1]

Yesterday, former New York Governor Eliot Spitzer lost his bid to return to politics as the Sheriff of Wall Street.  Mr. Spitzer was defeated in the Democratic primary for New York City Comptroller by Manhattan Borough President Scott Stringer.  This is a good outcome.  As I wrote in July, Mr. Spitzer’s campaign was based on profound misunderstanding of the challenges facing NYC’s public pension plan.[2]  Mr. Spitzer intended to focus on corporate governance, while the plan’s real problem is its long-term solvency.
Off-Brand Funds (1999)
Bank of America, Hewlett Packard, and Alcoa joined Mr. Icahn and Mr. Spitzer on the “out” list.  The three companies were removed from the Dow Jones Industrial Average (DJIA) in favor of Nike, Goldman Sachs, and Visa.  The ins and outs from the venerable DJIA index serve as two important reminders.

While the DJIA is a popular indicator for the stock market, it's a poorly constructed index.  The additions and subtractions from the DJIA are rather arbitrary, and the weighting of the index is based on the stock prices of the components rather than the market value of the companies.  For example, IBM at $186 per share has 23 times the weight in the index of Alcoa, which closed at $8 per share.  As a result, index investors replicate the S&P 500 or Russell 1000 when they’re interested in investing in large cap US stocks, not the DJIA.  In short, the DJIA is a handy barometer for the stock market but not a useful investment vehicle.

The latest change in the Dow Jones Industrial Average also reinforces the fact that our economy remains far too dependent on the volatile financial sector.  I italicized the word industrial because financial stocks did not enter the DJIA until August 1982, when American Express replaced International Harvester, a farm equipment company.  In 1991 JP Morgan was added, followed by Travelers Insurance in 1997, which shortly thereafter morphed into Citigroup with the fall of Glass Steagall.  As the financial sector swelled, Dow Jones added AIG (2004) and Bank of America (2008) to the index.  Within a day of collapsing in late 2008, AIG was removed, and Citigroup bit the dust nine months later.   The addition of Goldman Sachs and Visa
Simply reinforces the indexes tilt toward finance.
Are Goldman, Visa, and Nike “winning” companies that you ought to add to your portfolio?  The answer is a firm “no.”  Sometimes additions to the DJIA do well, and sometimes they flop miserably.  International Shoe, the last apparel company to grace the DJIA before Nike, lasted in the index for about a year back in 1932-33.  

General Electric is the only remaining original member of the DJIA.  All the other components merged into other companies or went bankrupt.  And GE, thanks to the financial crisis, sells at less than half of its peak price of $57.81 achieved in 2000.  One day, Dow Jones might even cast out Thomas Edison’s company.

[1] See my blog post, “Not Your Normal PE Deal: Dell (February 3, 2013)” which laid out the case that Mr. Dell would eventually win after slightly increasing his offer.
[2] “No Time for Corporate Governance: What Eliot Spitzer Inherits If He Runs and Wins” (July 11, 2013)

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