Apple In The Dow: Who Gets Booted?

| About: SPDR Dow (DIA)


Apple's split could lead to Dow 30 inclusion.

If Apple joined, who gets booted?

What do you base your decision on?

I think Travelers or Cisco could be the goner.

Last week, along with its tremendous earnings report, technology giant Apple (NASDAQ:AAPL) announced it would be splitting its stock. Unless a tremendous rally occurs in the next few weeks, this 7 for 1 split will put Apple's share price back below $100. When this split was announced, many thought that it could mean Apple will be added to the Dow Jones Industrial Average. Today, I'll discuss my thoughts on the issue, primarily the issue of who gets booted.

The mission of the Dow:

First, does Apple even qualify for the Dow? Here's what the Dow Jones website says about the Index:

The Dow Jones Industrial Average™, also referred to as The Dow®, is a price-weighted measure of 30 U.S. blue-chip companies. The Dow® covers all industries with the exception of transportation and utilities, which are covered by the Dow Jones Transportation Average™ and Dow Jones Utility Average™.

While stock selection is not governed by quantitative rules, 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.

Apple is not a transportation or utility company, so that works. The company has an excellent reputation and is of interest to a large number of investors. The one issue that some will claim is a problem is the "sustained growth" part. Apple is not the growth company it used to be, which the bear camp loves to tell us every day. However, there are a number of other components in the Dow who have had growth troubles recently as well, so I don't personally feel it is an issue. In regards to maintaining adequate sector representation, I'll discuss that in the next section.

What criteria are used for deletion?

The first item you could look at is market cap. Yes, the Dow 30 is a price weighted index, based on the trading price of the stock and not the market cap of the company. However, you might think that booting the smallest market cap company would better serve the "30 blue-chip name" statement. Remember, Apple has the largest market cap, so you'd be adding the biggest name here and subtracting the smallest. Based on Monday's close, Travelers (NYSE:TRV) has the lowest market cap, and Travelers' market cap is about half that of the next largest name in the index.

The next number in terms of size you could use is revenue base. Credit card company Visa (NYSE:V) has the lowest revenue base (in terms of current fiscal year estimates), with Travelers having the second lowest. Thanks to the Dow's structure, Visa actually has the largest weight, since it has the highest price. Nike (NYSE:NKE) has the third lowest market cap and revenue base.

The next item that you could use is index weight. With the Dow 30 being a price weighted index, those stocks with the lowest prices have the lowest weight. In fact, looking at the site for the SPDR Dow Jones Industrial Average ETF (NYSEARCA:DIA), you'll notice that a few names have a weight of around 1%. Right now, Cisco Systems (NASDAQ:CSCO) has the lowest weighting, under 1%, which means it has the least impact on the index.

By taking away the lowest weight, you would also re-weight the entire index. Let's say Apple replaces Cisco, and Apple comes in with about a 3% weighting. Adding Apple and replacing Cisco would lower the weight of all other names. This would provide a little more balance, and it would make the index a little less reliant on its top weightings, Visa and IBM (NYSE:IBM).

Finally, you could decide to change up the sector weightings a bit. For instance, you might decide that the financial sector needs to have a little less weight. Right now, that sector is represented by Goldman Sachs (NYSE:GS), Travelers, American Express (NYSE:AXP), and JPMorgan Chase (NYSE:JPM). Additionally, Visa, which has the largest weight, could be described as a financial service company. There is a conflict here about definitions, however. The DIA site I linked to above shows about 15% financial exposure and 19% information technology exposure. Visa is listed as an information technology company. However, the Yahoo! Finance page for the DIA shows about 24% financial and 11% technology, where Visa would be considered in the financial space.

I think there are two logical ways to go here. First, I think an Apple for Travelers swap would work for size and composition. You would swap a very large company for the smallest one in the Dow (by market cap). This would also reduce financial sector exposure and add a little more technology. The second name I would consider dumping would be Cisco, which has the lowest weight. This would add a little more tech exposure, and reduce the weight for all other names in the index.

What else this means for Apple:

If Apple were to make the Dow 30, it would mean the DIA ETF would need to buy Apple shares. According to the DIA site, as of Monday, the ETF held a little more than 4.5 million shares of each Dow component. That number would change a little thanks to the rebalancing of the index, but it's a good start for this argument.

This ETF alone would need to buy about 4.5 million shares of Apple, which would be equal to more than $2.6 billion. That in of itself would be like an extra buyback for Apple shares, on top of the shares Apple is buying back. Additionally, this doesn't include any other ETFs, mutual funds, or other funds that need to own Dow 30 components. Apple's buyback has already substantially reduced the outstanding share count and float, and a move into the Dow 30 could help even more. Obviously, I'm talking about an effective share count here, as we know the actual share count number will rise thanks to the split.

Final thoughts:

With Apple splitting its stock, speculation is growing that the technology giant will be added to the Dow 30. This would be a logical move for the index, but then someone has to leave. Personally, I think Travelers makes sense for a number of reasons, as it has the lowest market cap and second lowest revenue base. Additionally, this would reduce some exposure to the heavily weighted financial sector in the index. My second choice would be Cisco, which carries a weight of less than one percent. At the same time, Visa has a weight of nearly 8%, which points out the flaw that many see in this index. Swapping Apple for Cisco would boost technology exposure as well, and would reduce the weightings of every other name in the index, making a name like Visa a little less powerful.

Disclosure: I am long DIS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Author long Dow component Disney. Investors are always reminded that before making any investment, you should do your own proper due diligence on any name directly or indirectly mentioned in this article. Investors should also consider seeking advice from a broker or financial adviser before making any investment decisions. Any material in this article should be considered general information, and not relied on as a formal investment recommendation.