Foolish Four Portfolio
Dowdy Dow Dresses Up
Dumps frumpy stocks for flashy new ones

By Ann Coleman (TMF AnnC)

RESTON, VA (Oct. 26, 1999) -- This morning the Dow Jones Company announced that there will be a change in the companies used to make up the Dow Jones Industrial Average. Four stocks are being replaced, including two Foolish Four stocks. See today's Fool Plate Special for a rundown on the companies and thoughts about why each was chosen or dumped.

There are lots and lots of questions floating around about how this will impact the Foolish Four strategy, and I will try to tackle them all today and tomorrow. First, the facts: Current Dow component stocks Sears (NYSE: S), Chevron (NYSE: CHV), Goodyear Tire (NYSE: GT), and Union Carbide (NYSE: UK) are being replaced by Intel (Nasdaq: INTC), Microsoft (Nasdaq: MSFT), SBC Communications (NYSE: SBC), and Home Depot (NYSE: HD). The change takes place Monday morning.

It should be pretty obvious that the Dow is finally catching up to the rest of the country, and I definitely applaud the changes. (The debates about the Dow's relevance must have been increasingly annoying to the editors of The Wall Street Journal who select the Dow stocks.) Chris Rugaber discussed this possibility -- and suggested three of the four stocks that the editors eventually chose -- in Time for a Change last February.

With Sears and Goodyear at or near the top of the Foolish Four list, and Chevron showing up in the Top 10 list, this change will undoubtedly have an impact on Foolish Four investors.

First, let's put things in perspective. The Dow stocks change. They've changed an average of every four years since the index was first created; the last time was in 1997, which also resulted in a four-stock replacement. Second, Foolish Four stocks have been dropped from the index midyear before without necessarily disastrous results. We will take a much more in-depth look at that tomorrow. Third, remember: This is the Foolish Four strategy, the let's-go-fishing-today-and-worry-about-the-market-tomorrow strategy. Nothing has to be done right away.

So what do you do about these changes?

Nothing, nothing at all.

If you already own one of the stocks that was sold, the strategy assumes you will continue holding it for the full year. The way we handled this situation in our backtest was to simply ignore it. If a stock was "purchased" at the beginning of the year and later dropped from the Dow, it was simply held until the regularly scheduled renewal day. No big deal.

However, I would suggest that anyone looking to start or renew the Foolish Four today might want to wait just a bit. Tomorrow, we will be adjusting the Strategy Stocks Live! calculator to reflect the changes even though they don't officially take place until Monday. There seems little point in buying a Foolish Four stock that one knows will be dropped from the index, although one can certainly make the case that Sears and Goodyear are bargains today.

That brings us to the downside. Sears and Goodyear were the worst-performing Dow stocks today. In fact they were the worst by far, with Goodyear dropping almost 9% and Sears dropping over 6%. It looks like a fair number of investors decided to bail out of these troubled companies. Ouch. On the other hand, Chevron dropped less than Exxon (which is becoming the Dow's only oil stock) and Union Carbide barely budged, so one cannot conclude that being dropped is a death knell. We'll be looking at that some more tomorrow.

So why did Sears and Goodyear tank? My best guess is that investors who were already worried about Sears and Goodyear were spooked by the news into jumping ship for no particularly rational reason while Union Carbide and Chevron investors, who haven't seen their stocks diving for weeks, saw the delisting as the nonevent that it really is.

Or maybe it isn't. I confess, I am a bit worried. In the past the listing or delisting of a stock on the Dow had little impact because membership on the Dow was not something that mattered to investors. They bought companies, not "Dow stocks."

But lately, as strategies like the Foolish Four, Dogs of the Dow, and Beating the Dow have gotten more attention, many brokerages have formed Dow Unit Investment Trusts to follow those strategies. And then there are the Dow Diamonds. All of these Dow-based products increase demand for Dow stocks. It is certainly possible that as these institutional owners adjust their portfolios, the resulting drop in demand could have a negative impact on the companies that were dropped.

Of course, I am only speculating, and all I am going on is how an announcement that a company is being listed by the S&P 500 usually causes a short-term price spike for any company so blessed. Oh, yes, then there are the January price spikes we've seen when the Dow UITs start buying at the beginning of the year. So, I am a bit concerned. This really is a case where things are different now -- I just don't know how different. Most likely, not very much.

Still, that is the reason that I will be changing the stocks listed at Strategy Stocks Live tomorrow rather than waiting until the change takes place officially on Monday. Mind you, I'm not advising anyone to buy now and I am definitely not suggesting that anyone sell Sears or Goodyear because of this nonevent. (Most of the damage may already be done!) But this way, those who might want to start or renew a portfolio before the big boys start buying and selling on Monday will have the option to do so.

All of that is short term, though. If you are already holding one of these stocks, you can replace them if you like, but there is nothing in our backtest that supports doing anything other than holding. The companies are not any different off the list than they are on it, and their potential for recovery is not affected.

Contrary to some expectations, you won't see any change in the Dow's level due to the new stocks, although it might grow faster subsequently. The Dow's calculation will be adjusted so that the new stocks come in with no impact on the current level.

It's a simple process, actually. The published level of the Dow (now a bit over 10,000) is calculated by adding up the share price of each listed stock at any given moment and dividing that total price by the "Dow divisor." (The divisor used to be the number of stocks listed, but it has been adjusted for splits, spin-offs, changes, etc., over the years. It's now down around 0.19.) When you change the component stocks, you can simply divide the sum of the new Dow's stock prices by the old Dow level to get the new divisor. Thus the Dow's level won't change when the switch occurs, but it will change based on how the new stocks move from then on. I'm not sure when that will be done, but the Keepers of the Dow will probably use either Friday's closing price or Monday's opening price.

Although the Dow is supposed to represent the entire U.S. market, in practice it has usually only represented very big, very respectable companies. Lately it has gotten a reputation for stodginess that may or may not be deserved, but the addition of three high-tech companies and one high-concept retailer is right in line with the Dow's tradition of listing very good, very big U.S. companies.

Microsoft was something of a surprise, though. Not because it isn't good enough or big enough (ha!), but because it doesn't pay a dividend. I believe that Microsoft is the first non-dividend paying company to be listed, although Dow companies have dropped their dividends while listed. Come to think of it, that is usually a precursor to being dropped. It looks like the Dow folks are recognizing that dividends are no longer as important to investors as they once were.

Does THAT spell doom for the Foolish Four? Good question. Ask me in 20 years.

Fool on and prosper!

Today's Stock Lists | 1999 Dow Returns

Read More Foolish Four Reports

Top Dow Stocks
( RP Order )


1. Philip Morris
2. * Sears
3. * Goodyear Tire & Rubber
4. * General Motors
5. * Caterpillar
6. Eastman Kodak
7. AT&T
8. International Paper
9. JP Morgan
10. Chevron

NOTE: Today's Foolish Four stock selections are marked with an asterisk.

Foolish Four Portfolio

10/26/99 Closing Numbers
Ticker Company Dly Pr Chg Price
IPINTL PAPER-3/4$48.25
JPMMORGAN (JP)3/16$121.38

  Day Week Month Year
To Date
Foolish Four 1.48% .21% 1.99% 21.82% 23.63% 28.71%
S&P 500(DA) -.91% -1.52% -.06% 4.86% 4.92% 5.88%
NASDAQ -.16% -.18% 2.38% 28.22% 29.41% 35.90%
DJIA (DA) -.46% -1.61% -.34% 13.12% 13.29% 16.01%

Trade Date # Shares Ticker Cost/Share Price LT % Val Chg

Trade Date # Shares Ticker Cost Value LT $ Val Ch
  Cash: $119.51  
  Total: $4,945.26  

• S&P 500 (DA) = dividend adjusted. Dividends have been added to the total return of the index.
• DJIA (DA) = dividend adjusted. Dividends have been added to the total return of the DJIA.

The Foolish Four Portfolio was launched on December 24, 1998, with $4,000. Additional cash is never added, all transactions are discussed and explained publicly before being made, and returns are compared daily to the S&P 500 and the Dow. (Dividends are included in the yearly, historic and annualized returns.) Stocks are chosen once per year using a formula based on dividend yield and price. See The Foolish Four Explained for details.