The Dow Jones Industrials
But because of a quirk in the way it's calculated, the Dow doesn't give every company the weight it deserves. Later in this article, I'll talk about four companies that get short shrift from the Dow. But first, you need to understand why the Dow misses out on the full potential of some of its most promising companies.
Why the Dow has a weight problem
Behind every market benchmark is a set of procedures used to calculate it. The most important part of figuring out any index is determining how much weight to give to each of its component stocks.
Most market measures, including the S&P 500 and the Russell 2000, assign weights to their stocks based on market capitalization. So the stocks with the biggest market cap have the most influence on the index, while smaller stocks get less weight.
But the Dow is unusual in that it's a price-weighted measure. So regardless of how big a company happens to be, the only thing that determines how much weight it gets in the Dow is what its share price happens to be. So stocks with high prices count the most in the Dow, while low-priced stocks have much less influence -- even if their market caps happen to be extremely high.
4 stocks that you can't ignore (even though the Dow does)
Unless you plan to invest directly in the Dow, though, its weighting mechanism isn't important to you. You just want the best stocks you can find -- regardless of their share prices. So I looked at four stocks that have plenty of potential but happen to have low-priced shares currently.
Arguably the most diverse conglomerate in the U.S., GE has businesses that range from alternative energy and medical equipment to its now-minority interest in NBC Universal. GE fell out of favor during the financial crisis as its finance division suffered big losses that threatened the entire company.
Lately, though, GE has been firing on all cylinders. It's working with a variety of partners on initiatives including health-care information technology sharing and LED production, and it also expects to expand its aviation business significantly this year. Yet with a share price of just $19, the stock has only about a 1% weighting in the Dow.
This semiconductor giant has been successful for decades, riding on the surge in PC demand since the late 1980s. With in-house production facilities, Intel is insulated from third-party production problems that challenge some of its rivals.
With PCs giving way to mobile devices, Intel has had to answer a major threat. But with its Medfield mobile chip poised to find its way into tablets and smartphones later this year, Intel is positioning itself to join the mobile revolution. If it succeeds, then its roughly 1.5% weighting in the Dow won't do the chip company justice.
Pfizer has the largest market cap of any pure pharmaceutical company in the U.S., but by Dow standards, it gets almost no respect at all. It commands just a 1.25% weighting because of its share price around $21.50.
Like other pharma stocks, Pfizer is dealing with the setback of having lost patent protection on its blockbuster drug. But even with Lipitor open to generic competition, Pfizer has a reasonable pipeline of drugs to work on. Given the company's huge size, Pfizer is in a much stronger position to bolster its future prospects than many of its peers.
Cisco went through a rough patch a few years ago. Competitors seemed to gain the upper hand, and Cisco's customer base of government agencies found itself facing big cash crunches that hamstrung IT spending. Moreover, the company made some mistakes with its failed foray into consumer electronics as it failed to defend its core business.
But more recently, Cisco has gotten its act together. With a narrowed focus that goes back to the company's roots, Cisco's share price has climbed steadily since the middle of 2011. But even with its gains, the stock makes up only about 1.2% of the Dow -- less than a tenth of IBM's influence on the average.
The Dow is only as good as its component stocks, and sometimes, the Dow's methodology obscures its best companies. Be sure to look beyond the Dow average itself to find its most promising stocks.
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Fool contributor Dan Caplinger doesn't own shares of the companies mentioned. You can follow him on Twitter. The Motley Fool owns shares of Intel. Motley Fool newsletter services have recommended buying shares of Intel and Pfizer. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool has a disclosure policy.