Earlier today, the committee that oversees the Dow Jones Industrial Average (DJINDICES:^DJI) made its most extensive revision to the benchmark in nine years, switching out three existing Dow components in favor of three new entrants. The changes won't take effect for another couple of weeks, but that didn't keep investors from immediately starting a debate over whether the ejected stocks deserved their fate and whether the newcomers were the right picks to replace them.
Of the new stocks, Goldman Sachs (NYSE:GS) is certain to draw controversy among mainstream investors who primarily turn to the Dow for their views on the health of the stock market. Some feel the investment bank has essentially abandoned its reputation for honesty and integrity after the financial crisis, so many Americans will see the Dow's selection as rewarding a company which exiting executive Greg Smith said referred to customers as "muppets" to be taken advantage of for profit. With that in mind, does Goldman truly deserve to be in the Dow?
Delivering on fundamentals
If you only look at Goldman's financial results, you'll see an operation that has been incredibly successful in maintaining and growing its profits over the years. Despite a fiscal-year change that allowed it to push some losses into an "orphan month" in December 2008, the company's official annual reports showed positive earnings throughout the years leading up to and following the financial crisis, and profitability has slowly risen back toward levels seen before the crisis.
A big bull market in stocks was just what the doctor ordered for Goldman's prospects. In its most recent quarter, a combination of strong trading results and healthy investment-banking activity helped the Wall Street firm double its net income. Despite some headwinds from rising interest rates, Goldman has maintained long-term success in its proprietary trading operations, helping it earn a reputation for intelligence that has made it an industry leader.
Filling a financial void
One reason the Dow's selection committee might have chosen Goldman was to remedy a long-standing issue the Dow has faced: a much lower exposure to financial stocks than the broader market has. Before the switch, financials were significantly under-represented within the Dow, making up just 11% of its total weighting compared to more than 15% in the S&P 500. By itself, Goldman will resolve that issue by replacing Bank of America (NYSE:BAC): The price-weighted Dow gives Goldman about 11 times the weight that B of A had. Combine that with the addition of credit card giant Visa, and financials will now reverse their prior deficiency and have more influence on the Dow than they arguably deserve.
Some will argue that with just half of B of A's market capitalization, Goldman isn't large enough to deserve a place in the Dow. From a diversification standpoint, though, Goldman complements JPMorgan Chase reasonably well, as Goldman adds a larger component of underwriting and financial trading to go with JPMorgan's retail banking and credit card exposure. Among traditional investment banks, Goldman is bigger than Morgan Stanley and also avoids the issue of reuniting the two former halves of banker J. P. Morgan's empire in the collective investor consciousness.
Will Goldman earn its place in the Dow?
Looking forward, Dow investors will want to know whether the company will perform well enough to justify its elevation to the average. On that score, Goldman faces some challenges. On one hand, regulation requiring the investment bank to reduce its leverage has diminished Goldman's ability to take outsized risks in an effort to generate huge returns. That could limit the bank's profit-growth potential going forward, especially if it decides to retain the bank charter it got in 2008.
In its favor, though, Goldman isn't alone in dealing with the difficulties of a post-crisis world. Given the bank's healthier balance sheet, the risk of a complete implosion within Goldman is far smaller than it was before the financial crisis. As investors get more comfortable with Goldman's ability to maintain competitive advantages in a new financial-industry environment, the stock should at least have the potential to outperform its rivals. That in itself could be enough to justify the Dow's decision in many people's eyes -- even if they never come around to thinking that Goldman deserved its Dow spot.
Fool contributor Dan Caplinger owns warrants on Bank of America and JPMorgan Chase. You can follow him on Twitter @DanCaplinger. The Motley Fool recommends Bank of America and Goldman Sachs. The Motley Fool owns shares of Bank of America and JPMorgan Chase. 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.