Why Citigroup Is Destined for Greatness

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.

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Fool contributor Dan Caplinger thinks the major indexes have even worse timing than he does. He owns shares of Altria and SPDRs. Intel, Microsoft, and Pfizer are Motley Fool Inside Value picks. Kraft Foods is a former Motley Fool Income Investor selection. The Fool owns shares and covered calls on Intel. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy won't give you the boot.


Read/Post Comments (4) | Recommend This Article (23)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 05, 2009, at 5:30 PM, Netteligent09 wrote:

    Citigroup will go nowhere unless CEO Vikram Pandit resigns. Stock will surge within few days. If Citigroup is smart enough to select good CEO, stock continue to raise. Change Board of Directors will have a huge boosts while new team is workig to improve.

    Listen and learn for Hewlett Packard. It is the only way.

  • Report this Comment On June 05, 2009, at 5:55 PM, FinancialFellow wrote:

    I hope Citibank manages to survive, then thrive. It's a great time to be in the banking business. Ignoring the large amout of bad debt the banks are doing quite well. Interest rates are low and government assistance is plentiful.

    That said they still have some serious issues. The largest is of course clearing out their bad debt. I suspect banks will also see some erosion in their lending by online peer to peer lending offering better returns for investors: http://financialfellow.com/2009/04/22/peer-to-peer-lending-o...

    Peer to peer lending also offers better rates for borrowers. Who would pay 20%+ on a credit card when they can get an interest rate of 8%: http://financialfellow.com/2009/06/02/how-to-borrow-up-to-25...

  • Report this Comment On June 07, 2009, at 4:51 AM, automaticaev wrote:

    whats wrong with pandit he got some damn good insurance for his company from the government. Its down to 3.50 right now mabe it can go lower.

  • Report this Comment On June 07, 2009, at 11:41 AM, joaquingrech wrote:

    Dan,

    I think this article is wrong. First, it failed to explain the purpose of the Dow. Is the Dow supposed to pick the best performing stocks? If so, it does a horrible job.

    On the other hand, if the Dow is an index representing 30 of the largest and widely held companies, it does seem to just do that. In fact, if it should be representative of how the market is performing as a whole, the stock picks (msft drop, intel drop, aig drop, etc...) seemed to be closer to the average performance of the market that the ones that went up during a bear market.

    Second, the title "Why citigroup is destined for greatness?" was it ever answered in the article? I came here to read why citigroup is destined for greatness, and it seems the only reason provided is because something being kick out of the Dow doesn't relate to the stock performance.

    Please, don't get me wrong, but I did really want to see a throughout reasoning about citigroup's future, I'll be more than happy to read a second installment of your article.

    Regards,

    Joaquin Grech

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