Value Still Exists in the Dow

Making a series of new lows, the Dow Jones Industrial Average seems to have no support from a technical point of view, but if you pick through the 30 members I think the upside here far outweighs the downside.

If the 15 smallest-weighted DJIA stocks plummeted to zero, that would wipe out about 22% of the index, which to me actually sounds bullish. Among those 15 – thanks to the Dow’s methodology – are Microsoft (MSFT), Intel (INTC), Kraft (KFT) and AT&T (T), just to name a few. The point being, there are not 15 Dow stocks headed to zero. Citi (C) and GM equity is likely worthless, but that amounts to less than 1/2 a percent of the index, or 31 points. Wipe out “leveraged blue-chips” GE and Alcoa (AA), and BofA (BAC), and the index loses a combined 2.5% or 177 points, an afternoon’s work for the Dow as of late.

Using 10 year average EPS, the Dow trades at a weighted multiple of 16 – a level that argues for sub-par returns going forward, as demonstrated by Yale’s esteemed Robert Schiller. However, largely impacting that are CVX and XOM, whose earnings are up eight and eleven-fold. While a decline in profit for these stocks will be in order, they’re not headed back to 1.00 per share in earnings, and their mini-PE’s discount the earnings drop. IBM trades at a trailing 9 times earnings, and PG and JNJ trade around 12 times both forward and trailing estimates – amazing values for these best-of-breed companies. The Dow stocks trade, on average, at a 63% discount to 10 year their average trailing PE ratios. There are numerous potential double’s and triples in the Dow, including HPQ and BA at 8 and 9 PE’s.

Leaving aside PE’s, the Dow 30 is attractive on a Free Cash Flow basis as well, with the top two stocks’ FCF yielding 11 and 12% of their (net of cash) Market Caps. I’m not one to ignore debt in the capital structure, but the interest coverage ratio’s of the Dow stocks are lavish – the top 83% of the index has an average EBITDA/Interest ratio of 49, thanks to the oil majors.

There is some serious garbage stinking up the Dow, but thanks to the index’s price-weighted methodology, their damage has largely been done. Meanwhile, great companies can be had at great prices by owning this index, and I think the future will reward those who put money to work at this level.

Disclosure: Author is long DIA.

Comments

[drone:]

The Dow will be okay if they ditch those sub $10 bank stocks and GE. Put those guys out of their misery, it would teach them a lesson.

Feb 24 06:06 PM

[drone:]

At the same time put David Dreman - an unsuccessful investor in these deep value traps - out of his misery.

Feb 24 09:12 PM

[Marcap:]

First of all, I do not agree with the current make-up of the DOW. It no longer accurately reflects the US economy in general. There are a number of companies currently in the DOW's 30, which in my opinion, should no longer be there, among them Citigroup, Bank of America, General Motors and GE.

Nonetheless, if all current 30 companies making up the DOW adjusted their Balance Sheets getting rid of Goodwill and other Intangibles Assets (most with little if any real value), not to mention all the bad bank loans, so as to more closely reflect reality, there would most likely be a massive drop in the share prices of those companies, resulting more than likely in the DOW dropping perhaps to 3000 points or less.

So the question we should be asking ourselves is this: What is more acceptable to us? Continuing to allow ourselves as investors to be misled by these companies with their over-inflated Balance Sheets, or allowing the DOW to drop to a much more realistic and accurate level?

Feb 24 11:45 PM

[henarl:]

As Marcap states, the Dow is not the market. The S&P 500 is a much more accurate indication of the market and still does not work if you are an investor in individual stocks rather than index funds. Picking individual stocks are even sector ETFs is the way to go in a bear market. Also, short term trading rather than buy and hold is better now. It's more work but will have better results.

Feb 25 01:20 PM

[ArtfulDodger:]

BW wrote: " the Dow 30 is attractive on a Free Cash Flow basis as well..."

I wouldn't invest in the DOW, but there are several stocks within the DOW Index that are cheap relative to their FCF. And I've discounted the worst-case-senario in each case.

Of course, being cheap doesn't mean any stock will go up, or down. It simply means they're cheap.

Feb 25 05:20 PM