Given how much attention the Dow Jones Industrial Average gets from everyday investors, you'd think that getting kicked out of the Dow would be the kiss of death for an ailing company. But while General Motors shareholders shouldn't expect their shares to be worth anything by the end of that company’s bankruptcy proceeding, past history suggests that when Cisco Systems (Nasdaq: CSCO ) and Travelers replace Citigroup (NYSE: C ) in the Dow next Monday, it may well be the battered financial firm that has the last laugh.
How now, Dow?
Over the past 10 years, the Dow provides some great examples of bad market timing. The most egregious example came in late 1999, when the average replaced several old-economy companies, such as Chevron (NYSE: CVX ) , with then-booming tech giants Microsoft (Nasdaq: MSFT ) and Intel (Nasdaq: INTC ) , along with some other newer companies. Over the ensuing two years, Chevron managed a small gain, while both Microsoft and Intel fell prey to the tech bust; both dropped over 30%.
In 2004, the Dow made some other major changes. International Paper, Eastman Kodak, and AT&T were replaced by Pfizer (NYSE: PFE ) , Verizon, and AIG. Again, by 2006, Pfizer had dropped over 25%, while Kodak had posted a 14% gain.
Out of the frying pan, into the fire
Last year, the Dow made another infamous set of replacements, putting in Bank of America and Chevron to replace Altria Group and Honeywell. Since then, Bank of America has dropped nearly 70%, and it was down much further in March before the recent run-up that nearly quadrupled its share price.
Most recently, though, the Dow finally made a smart decision, replacing AIG with Kraft Foods. Already battered, AIG has fallen another 65% since September, while Kraft has held up much better.
Never a good bet
In fact, the Dow's dubious track record for choosing replacements goes back much further than the past decade. A study done early last year from a Pomona College economics professor looked at 50 substitutions made since 1928, excluding replacements due to mergers or name changes.
The study's results showed that over that time span, stocks that were dropped from the average outperformed stocks that were added by an average of nearly 16 percentage points. Moreover, removed stocks continued to outperform the new Dow components for as long as five years after they were taken out.
Does the Dow matter?
Of course, even discounting a history of bad stock-picking, the Dow already has its denouncers. As one of the few price-weighted averages among major market indexes -- most, like the S&P 500, are weighted by their components' market caps -- the Dow gives disproportionately large influence to small companies that happen to have high share prices. For instance, at less than $20 per share, Cisco will have just a fifth the influence of IBM (NYSE: IBM ) -- even though Cisco's market cap is just 20% less than IBM's.
Also, anyone counting on index funds to boost shares of the new Dow components is likely to be disappointed. The Dow isn't a very popular tracking benchmark for index funds and ETFs -- Dow-tracker Diamonds ETF has just $7 billion under management, compared to more than $60 billion for the S&P-tracking SPDR Trust. Given how much news coverage is given to changes to the Dow's components, you'd think they'd have a bigger effect on your finances. But they really don't.
So while Monday's changes to the Dow will inevitably garner more headlines, you shouldn't feel any pressure to rush out and buy shares of Cisco and Travelers as soon as they join the Dow. Even though the companies may enjoy a little bump in their prestige from their inclusion in the Dow, you shouldn't count on them to be great performers in the near future.
And who knows -- if Citigroup survives, it could easily end up being the latest in a string of outperforming Dow rejects.
Learn more about smart investing here: