The Dow Jones Industrial Average (^DJI -1.44%) is getting its biggest shakeup in seven years, announcing a trio of moves including swapping out aerospace specialist Raytheon Technologies (RTX -0.72%) with the more diversified Honeywell International (HON -1.86%).
Despite the glib headline, the committee behind the moves is not offering investing advice. In a statement, S&P Dow Jones Indices, which runs the index, said the moves were prompted by Apple's pending stock split and by a desire to "diversify the index by removing overlap between companies of similar scope and adding new types of businesses that better reflect the American economy."
Nevertheless, many people will buy and sell these stocks based on the news, and index funds that track the Dow index will be forced to buy the new additions and sell the companies leaving the index. Whether it's in the index or not, here's why investors are right to prefer Honeywell to Raytheon right now.
Raytheon's a good company stuck in a bad place
Raytheon Technologies was formed earlier this year via the merger of the aerospace arm of United Technologies and defense contractor Raytheon. The deal couldn't have come at a better time for United Technologies shareholders, since the COVID-19 pandemic devasated United Technologies' commercial-focused business. United Technologies makes the Pratt & Whitney engines that power large commercial aircraft, and its Collins Aerospace unit makes cabin interiors and flight control systems. With airlines significantly cutting back on flights and air travel demand waning, it's not a great time to be focused on commercial aircraft.
Post-merger, about 55% of the newly formed Raytheon Technologies' revenue comes from defense and space, providing a nice cushion as the commercial side struggles. The Pentagon kept spending even as commercial aerospace dried up, and national defense priorities should continue to get funding even if the U.S. falls into a recession. Still, the company's shares are down 36% year to date and CEO Greg Hayes last month warned he expects it to be at least 2023 before commercial air traffic returns to 2019 levels.
Thanks to the Raytheon defense business, the company is one of the safer bets among stocks with significant commercial aerospace exposure. But the company is also in the early stages of a major merger integration, and its going to be hard for Raytheon Tech shares to break out until airlines are flying again. If Hayes is right and that takes three years or more, investors are likely to be in for a long wait.
Honeywell: More tech, less uncertainty
Honeywell has its own aerospace business, and its own COVID-related woes, with organic aerospace sales down 27% in the second quarter. But Honeywell has a far more diverse set of businesses, and has already pruned its underperformers. Its units focused on building technologies, performance materials, and automation, while impacted by the pandemic, should bounce back much quicker than aviation.
What makes Honeywell a standout is the company's focus on complementing its industrial portfolio with technology. In years past, that included acquisitions like Intelligrated, a warehouse automation platform that the company sells to its existing fulfillment and distribution customers.
More recently, Honeywell has made headlines for its computing prowess. In March, the company announced what it called "the world's most powerful quantum computer," designed to solve complex problems in its core aerospace and materials businesses, in addition to other industries through its partners like JP Morgan & Chase.
Honeywell does have some warts. In addition to its aerospace unit, its exposure to energy could be a drag in the quarters to come. However, the company boasts a well-diversified portfolio and management's focus on tech should serve investors well over time.
The future is bright for both Honeywell and RTX
Honeywell and the former United Technologies have been closely associated with each other for years, with Honeywell making a hostile attempt to buy United Technologies in 2016.
Honeywell "won" this round, but over the long-term, both look like winners. Raytheon's biggest strike against it might have been its similarities with Boeing (BA -3.55%), another Dow component that is off 46% for the year and which has dragged the index down with it. Boeing has a similar mix of commercial and defense aerospace assets. If the Dow committee was looking to diversify, sacrificing one of the two names makes sense.
I believe both of these stocks can outperform over the long-haul, but the turbulence Raytheon will face in the next three to five years will likely be stronger than what Honeywell faces. As a result, I expect Honeywell to be the better stock during that window.
For Raytheon Technologies holders, though, there is reason for hope. Honeywell is coming back into the index after being kicked out twelve years ago. Raytheon could very well get another shot down the road.