Would a Reverse Split of General Electric and Microsoft Stock Help Balance the Dow?

Two of the world's largest companies are drastically underrepresented on America's landmark stock index, but there's a relatively easy fix for that.

Jul 14, 2014 at 4:33PM

General Electric (NYSE:GE) and Microsoft (NASDAQ:MSFT) are undoubtedly two of the most important public companies in the world. Both are still among the 10 largest public companies in the world, more than a decade after the dot-com bubble pushed both of them to all-time highs (GE was actually the world's most valuable public company for much of the dot-com era, until Microsoft surged past it in the summer of 1998). Because the S&P 500 (SNPINDEX:^GSPC) weights its components by market cap, GE and Microsoft are among the 16 S&P 500 stocks to account for more than 1% of its daily movement.

But despite all of their success, GE and Microsoft are perhaps more marginalized than any other components on the Dow Jones Industrial Average (DJINDICES:^DJI). The Dow, unlike the S&P, weights its 30 components by share price, which penalizes companies that prefer to keep their share prices in a lower double-digit range. Despite being the fourth-largest company in America by market cap, Microsoft is No. 24 out of 30 Dow stocks with a weighting of about 1.6%. GE, which is America's eighth-largest company by market cap, is No. 29 with a mere 1% weighting -- lower than its 1.5% weight on the S&P!

This might not seem like a huge problem, as the Dow and the S&P have both moved in close proximity to each other for much of the past 30 years. But both indexes are supposed to assess the overall health of the American stock market, and a divergence since the dot-com bubble popped has made one of these indexes seem less reliable than the other:

^DJI Chart

^DJI data by YCharts.

Over the past year, the Dow and S&P have reversed roles, with the former falling rather far behind the latter, to the point where both GE and Microsoft outperform it -- although only Microsoft outperforms the S&P as well:

^DJI Chart

^DJI data by YCharts.

This is clearly not the fault of either GE or Microsoft, since neither has that great an impact on the Dow from day to day. It's largely the fault of those in charge of selecting new index representatives, as last year's financials-focused swap brought in two of the top three most heavily weighted Dow components. However, there's no inherent reason why either company's shares should be among the cheapest of all 30 Dow stocks.

Microsoft has split its shares nine times since going public in 1986, and GE has undertaken five splits in the past 30 years. Without those splits, one Microsoft share would be worth more than $12,100, and one GE share would be worth nearly $1,300. That would price both stocks out of Dow membership. But what if each stock would reverse-split three-to-one from current levels? One Microsoft share would then be worth about $126.25, and one GE share would be worth about $79.50.

How would that change the Dow's weighting? For one thing, GE would account for nearly 3% of the Dow's daily moves, and Microsoft would account for 4.5% of the Dow's momentum. Both percentages under-weight these two companies relative to their market caps, but they come a lot closer to a fair representation under these new share prices than they ever have before.

Having only a third as many GE and Microsoft shares on the market (thus making each share three times more valuable) would probably help the Dow regain parity with the S&P 500 in the future. It would probably also have the effect of dragging the Dow down to parity with the S&P if applied retroactively to the past. Since it joined the Dow in 1999, Microsoft has been one of the index's worst performers despite a surge over the past year, and GE's reliance on its financing arm dragged it even further down in the financial crisis, making it one of the Dow's biggest laggards over the past decade:

^DJI Chart

^DJI data by YCharts.

Higher share prices wouldn't change anything else about these stocks, but it would help balance an imbalanced Dow. The Dow is far from perfect, but it can still be a reasonable representation of the American economy -- with a little help from its components.

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Alex Planes holds no financial position in any company mentioned here. Add him on Google+ or follow him on Twitter @TMFBiggles for more insight into markets, history, and technology.

The Motley Fool owns shares of General Electric Company and Microsoft. 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.

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