The Dow Jones Industrials Average (DJINDICES:^DJI) is cleaning house. After today, Goldman Sachs (NYSE:GS), Visa (NYSE:V), and Nike (NYSE:NKE) will replace Alcoa, Bank of America, and Hewlett-Packard.
This raises some interesting questions -- is the Dow's blessing really a good sign for investors? Or is it a kiss of death for outperformance? What's the track record of the new Dow members, anyway?
For all the hype and adulation that goes along with Dow membership, history suggests that the folks picking new members are much better at identifying stocks that have performed well in the past than stocks than those that are poised to perform well in the future:
Performance declined an incredible 86% of the time a stock was added to the Dow.
Now, to be fair, Dow Jones isn't exactly aiming to identify outperformers when it selects new members. As they explain: "A stock typically is added to The Dow only if the company has an excellent reputation, demonstrates sustained growth and is of interest to a large number of investors. Maintaining adequate sector representation within the indices is also a consideration in the selection process."
And maintaining sector representation in the most prominent industry names during a period of two major bubbles is the big culprit here. Much of the decline in performance comes from giants that were added at the peak of sector bubbles. Intel (1999), Microsoft (1999), AIG (2008), and Bank of America (2008) are prime examples.
Still, when you compare new Dow members to the broader market, they actually do pretty well on average. New members beat the broader market by 32 percentage points over the five years after they're added.
However, keep in mind that this outperformance was largely due to a small group of major outperformers. (Owing the bulk of your performance to a relatively small group of companies is a feature of the broader stock market too.) New Dow stocks usually go on to underperform the market.
So, what are the historical lessons here for investors, particularly those interested in new Dow members like Goldman, Visa, and Nike?
- Sadly, the pomp that goes along with getting added to the Dow is also a sign that a stock's best days of performance are behind it. This makes sense, because companies grow into their blue chip status, but the law of large numbers, and the extra attention from big investors makes outperformance difficult to continue.
- Most new Dow members have gone on to underperform the S&P 500, though performance as a group was better than the market as a whole because of a select group of Dow all-stars.
- It's apparently much harder to separate true "blue chip" companies from momentum stocks nearing the peak of a bubble. Even some genuine blue chip companies can be overvalued momentum stocks.
- Simply buying a few of the most prominent names with "interest to a large number of investors" isn't as safe a stock-picking strategy as you might think. Even investors interested in prominent stocks still need diversification to make it work.
Ilan Moscovitz has no position in any stocks mentioned. The Motley Fool recommends American International Group, Bank of America, Goldman Sachs, Intel, Nike, and Visa. The Motley Fool owns shares of American International Group, Bank of America, Intel, Microsoft, Nike, and Visa and has the following options: long January 2014 $25 calls on American International Group. 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.