Dow Shake-Up Explained

In this episode of MarketFoolery, Chris Hill chats with Motley Fool analyst Jason Moser about the latest headlines and earnings reports from Wall Street, including the second-quarter results of a major retailer. They also discuss the simultaneous exit and entry of three stocks in the Dow and the reasons behind the shake-up. Finally, they dip into the Fool mailbag, the basket approach to investing, and much more.

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This video was recorded on August 25, 2020.

Chris Hill: It's Tuesday, August 25th. Welcome to MarketFoolery. I'm Chris Hill. With me today, the one and only, Jason Moser. Good to see you.

Jason Moser: Good to see you. How's everything?

Hill: It's going all right. We've got a shake-up in the Dow Jones Industrial Average, we're going to talk about the basket approach to investing, but we're going to start today with Best Buy.

Online sales in Best Buy's second quarter grew 240%. And profits and revenue in the second quarter were higher than expected. But once again, [laughs] online sales year-over-year up 240%. The numbers just keep getting bigger for [laughs] these retailers in terms of their online sales growth. Shares of Best Buy are down about 5% today, but, Jason, I feel like this is the home electronics and appliances version of what we saw last week with Home Depot and Lowe's, you know, putting up great numbers, the stocks selling off the day of the report, in part because, in the case of Best Buy, it's had a pretty amazing run, it's up 70% in the past year.

Moser: Yeah. And it wasn't all that long ago -- I mean, a lot of us, not just at The Fool, but generally in the financial community, investing community, were looking at Best Buy as a pretty ideal short candidate, right. Thinking, OK, well, we're now entering this new Amazon world and how is Best Buy going to survive this? And you fast-forward to today, clearly, they have survived it, they've done very well. It's been a good year for the stock, it's been a good past year for the stock, good year to date. And you know, I think the silver lining for a lot of businesses during this pandemic, it's given them a chance to redefine themselves, maybe to hit the reset button a little bit in an effort to prove their mettle in what is likely to be a new world going forward, at least to some extent.

And to that point, we saw, there's some interesting perspective on the call from CEO Corie Barry, who said that she noted three concepts they believe are going to be permanent structural changes, implications from this pandemic. And one, customer shopping behavior will be permanently changed in a way that's even more digital and puts more customers entirely in control of how to shop for what they want and shopping how they want. I think that's right. Two, the workforce is going to need to evolve in a way that meets the needs of customers while providing more flexible opportunities; I think that's right. And three, technology is playing an even more crucial role in everyone's lives due to the pandemic, and that certainly would give a company like Best Buy more reason to invest in technology, not only on the backend but, really, also on the consumer-facing side as well, bringing more of that tech to consumers.

And then as you noted, [laughs] the online sales numbers are just phenomenal. Domestic online revenue grew 240% from a year ago. And interestingly, as a percentage of total domestic revenue, online revenue increased to approximately 53% of total domestic revenue versus 16% a year ago. So, not that surprising given what we're going through, but it's nice to see that Best Buy is not only capitalizing on it, but it seems like they have a really good framework on how to take this business forward.

Hill: The one thing that surprised me in the report, Best Buy saw growth across most of their categories, you know, computing, tablets, home appliances, they didn't see growth in home theater. And that surprised me a little bit, considering everything we've talked about [laughs] over the last few months about people being in their homes binge watching; you know, the rise of Netflix, Disney+ all this sort of thing. It does, however, make me wonder if the next six months for Best Buy are set up in such a way that we are going to see a nice bump in the home theater segment.

Moser: I think there's a lot of potential for that. I think that, you know, we've gone through these last six months or so with a lot of uncertainty in exactly how things are going to be once we get past this pandemic, whatever that looks like. And so, I mean, are movie theaters going to come back? If not, what does that look like? How are studios and how are these businesses distributing their content going forward? I mean, we're seeing Disney, of course, experimenting with throwing stuff out there on Disney+. And so, I would imagine, part of that is just some uncertainty in exactly how things are going to look in the next year. And then what that ultimately looks like going forward as kind of our new normal.

And I think it's also probably fair to say that those are bigger ticket items, require a little bit more deliberation and we've got a holiday season coming up here. So, it's probably pretty reasonable to think that if people are starting to think about that stuff, they're trying to get, you know, in their minds exactly what that looks like, but also thinking, hey, once they get that picture in their mind, the holiday season coming up, I mean, there's going to be a great opportunity to really go in there and look for things like that.

And management did note on the call, while they've been very good about keeping control on the expense side SG&A, for example, they kept a lid on SG&A, which enhanced profitability for the quarter. But they are going to spend more on SG&A, advertising campaigns, getting back out front and center for the consumer for this holiday season to try to take advantage. And I think Best Buy is one of those companies that could be in a great position for this holiday season; assuming that we don't see some "second wave" or see more pandemic problems developing. Hopefully, we can keep things going the way they're going. I think Best Buy is set up for potentially a really, really nice holiday season.

Hill: Next Monday, the Dow Jones Industrial Average will be changing 10% of its index; it's the biggest shake-up of Dow components since 2013. Being added are Amgen, Honeywell, and Salesforce.com. Exiting stage left are Pfizer, Raytheon, and ExxonMobil. Pour one [laughs] out for ExxonMobil, that has been in the Dow since 1928.

You and I were talking a little bit about this this morning. I'm a little confused [laughs] by this combination of moves. I think if it had just been as simple as, we're putting in Salesforce.com, we're taking out ExxonMobil, that would have made sense to me, at least on the surface of it. But you did some digging and there's, I think, some pretty compelling reasons behind these moves.

Moser: Yeah. And it all goes back to one word, and that is Apple. [laughs] Apple is, as we know, a member of the Dow, and the Dow being a price-weighted index, that has a big impact on how these companies contribute to the index. And so, this move that we're seeing today, these three out, and three in, this is essentially a rebalancing act. I mean, this is an effort to diversify the index, because of the fact that Apple is splitting. And so, we know Apple splitting 4-for-1, ultimately what that does, it's going to, again, because of the price weighting nature of the index, it reduces the weighting of information technology in the index, it reduces Apple's per-share basis impact on the index. And so, you know, that one split has all sorts of interesting ramifications to the index as a whole.

And, I mean, that's ultimately what this boils down to. And so, you're seeing these one-for-one, kind of, companies where Raytheon and Honeywell; yeah, you can draw the parallels there. You know, certainly, Amgen and Pfizer, you can draw the parallels there. Exxon and Salesforce; maybe not so much, [laughs] but like you said, I mean, let's pour one out for Exxon, because I think, you know, when you look at the numbers it starts to make a little bit more sense in why these new companies are coming in. And just looking over the last 10 years, for example, if you look at the comparisons Pfizer versus Amgen over the last 10 years, Amgen has returned 377% versus Pfizer's 142%. Honeywell has returned 328% versus Raytheon's 46%. And then ExxonMobil, unfortunately, is in the negative there -- down about 30% -- while Salesforce has returned close to 660%.

So, you can see part of this is, you know, there's an attractive nature to getting your index a bit more forward-looking, a bit more, kind of, where the puck is going, so to speak. But then also, it's interesting to think about the implications just from the actual nominal share prices here. I mean, when you look at the actual share prices of some of these businesses that are going to be coming in, again, going back to that price-weighted nature of the index. I mean, Pfizer is just about $40/share; Amgen, on the other hand, is somewhere in the neighborhood of, I mean, it's close to $250/share. So, just that switch alone is going to give the index more exposure to that industry just based on the nominal share price. And you see the same dynamic with Honeywell versus Raytheon and with Salesforce versus Exxon, although to a lesser degree.

But yeah, at the end of the day it's a rebalancing act. I don't know that I would read a whole heck of a lot into it. I'm sure there's some politicking that goes on as far as determining what companies are going to go in there, but I think this really does all, [laughs] kind of, trace back to Apple, interestingly enough, and it probably is a wise move. I think it makes the index a bit more representative of the American economy. And it gives -- and not only just the American economy, really the global economy. And that also gives, you know, all of the members a bit more of a say so in the index.

Hill: Do you think anyone at Pepsi [PepsiCo] looks at the Dow Jones Industrial Average, looks at their performance relative to Coca-Cola's over the last few years and just says, come on! [laughs] Swap us in for Coke, come on! We're doing better than Coke; or do you think, you know what, it just doesn't matter?

Moser: [laughs] No, I think it does matter. And I think, you know, we talk about skating to where the puck is going. Let's just doff the cap there to Pepsi, because they're the ones making all of the investments in the salty snacks and the foods and diversifying away from just being a beverage company. I mean, hey, listen, I moved up here from Georgia, I'm a Coca-Cola guy, but the facts are the facts, right. Maybe it is time for a switch, maybe it's time for Pepsi to take that title and Coca-Cola to take a backseat, because certainly it's been the better stock to own over the last several years.

Hill: Our email address is [email protected]. Question from Scott Morrissey. He writes, "I'm a proud Fool since 2006, and one of the dozens of happy MarketFoolery listeners. I really enjoy the market basket approach to investing in businesses riding secular trends. When you start a basket and spot a leader in the sector, do you invest more capital in that business at the outset and less with the others or do you start with equal weight positions and deploy more later in the individual businesses based on conviction and opportunity? I don't know what I don't know, so I tend to go with equal weight, what do you think of that approach? Thanks for everything you do."

Thank you, Scott, for listening and for a great question. I mean, in the baskets that you've created, Jason, the War on Cash basket, the Health & Wellness basket, unless I'm mistaken, I think you've gone the equal weight route right out of the gate?

Moser: That is correct. And, Scott, I like the way you think. You said a lot of good things in there, I like that, "I don't know what I don't know." And as investors, I mean, it's really important to know that. [laughs] I think we've said the word "know" too many times, but it's really important to know what you don't know. And if you don't know what you don't know, then, hey, you're at least saying that you know that you don't know what you don't know. So, that's good.

If everybody is thoroughly confused, now we can move forward. So, you're right, Chris, we start out equal weight. And that's really for two reasons. It's No. 1, it keeps it simple. And that was part of the idea behind the basket approach, we're going to simplify this. Just try not to make this too difficult. And also, while leaders can be obvious in hindsight, they're not always so obvious when you put together a portfolio.

And also, it's worth noting that market leaders may not necessarily be your returns leaders either, there is a difference. And so, I'll use Visa versus Mastercard, for example. If we just look at the War on Cash basket, the four components of that basket, which are Visa, Mastercard, PayPal, and Square. Well, Visa, that's the market leader in the payments space in the sense that they are the biggest, they have the most cards out there, the network is the biggest. And so, when you look at it from that perspective, that's the leader. Yet, over the time of the basket's performance, Visa is the worst performer. And when I say, the worst performer, I mean, listen, the stock has doubled since the basket was formed, so it's not like it's performing poorly, but when you compare it to the other three, Visa is in fourth place. So, you know, that leader isn't necessarily the returns leader either, and that does make a difference.

So, the idea behind baskets really is to find, I guess, leaders in this space, where we know there's this big opportunity, but then trying to find leaders that fit into different risk categories. And so, with the War on Cash, for example, you got Visa and Mastercard, those are, kind of, your stalwarts. And then you've got PayPal, which is, you know, that's a company that's maybe sort of that mid-range risk tier, although that's really become less risky overtime as well. Square being a little bit of a higher risk. So, you've got leaders in their respective spaces.

But keeping it equal weight, I think is an easy way just to keep it simple. And then it's also worth noting too that as time goes on, and this is the nice thing about these baskets is, you start them out equal weight, as time goes on, things become a little bit more apparent to us as investors. We see certain companies are performing better than others. We become a little bit more convicted of some companies as opposed to others. There's nothing that says you can't start adding more to those winners as time goes on. And I've done that personally, I mean, I've got money in all four of those payments companies, and through the past couple of years, I've added more money to PayPal and Square as opposed to really adding to my Mastercard and Visa positions. And, you know, part of that is just because I felt like I could assess some performance there. And I didn't have any problem taking on a little bit more risk, and maybe that overexposure.

But definitely, starting out with that basket, I think equal weight makes the most sense. And from there, there's nothing that says that you can't add to those winners as time goes on.

Hill: I don't know if we talked about this at the time, but I remember thinking when you set up the War on Cash basket a few years ago, looking at those four companies. I remember looking at Square [laughs] and thinking to myself, like, not so much like, ah, they might go under, it was more like, ah, someone might buy them. Like, they may not be in the basket in a few years because someone might just snap them up. But you know, as you said, that's one more reason to go the equal weight route.

Moser: Yeah. And I did consider that as well; I considered both of those. I mean, there was a greater than 0% chance that Square could have been acquired or that it could have gone under. You know, it was a brand-new business, it was losing money hand over fist. So, there was a bit of a leap of faith involved there. And so, yeah, you could see those scenarios play out. You look at something like a Visa and Mastercard, yeah, they might not light the world on fire, but I'm 99.9% certain that those businesses are not going under. And that's really where that risk profile comes into play and why those baskets can work so well, because they're like your own little mini fund, and that's a lot of fun to manage your own money like that.

Hill: Jason Moser, always good talking to you. Thanks for being here.

Moser: Thank you.

Hill: As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear.

That's going to do it for this edition of MarketFoolery. The show is mixed by Dan Boyd. I'm Chris Hill. Thanks for listening. We'll see you tomorrow.