Apple Doesn't Belong In The Dow 30

May.31.12 | About: SPDR Dow (DIA)

The chorus to add Apple (NASDAQ:AAPL) to the Dow Jones Industrial Average (DJIA) has reached a fever pitch, as this iconic company wears the crown for the world's largest corporation. On May 29, 2012, Apple closed near $570, which translates into a $525 billion market capitalization. On paper, a logical argument could be made to replace Dow laggards, such as Merck (NYSE:MRK) or Hewlett Packard (NYSE:HPQ), with Apple. If Apple were to be added as a Dow stock, is it likely that shares would receive a short-term boost, due to increased reverence for the corporation alongside demand from index funds that would automatically begin accumulating shares.

I, however, would strongly caution against trading Apple shares due to any looming Dow Effect. As a long-term investor, it is critical that you focus your fundamental analyses upon Apple's strong earnings record and cash pile, rather than any speculative, potential one-time event. Taken further, I would even argue that Apple is a special case that will be left outside of the Dow, as a component stock. At this time, basic mathematics alongside the composition of the U.S. economy do not allow for Apple's inclusion within this most venerable index.

Calculating the Dow

On May 26, 1896, journalist Charles H. Dow put together his own industrial average to help investors gauge the direction of the overall stock market. In simpler times, Mr. Dow merely took the sum of the share prices of the twelve stocks within his index and divided by twelve - to take an average. Over time, the Dow Jones Industrial Average expanded to thirty stocks alongside a divisor. Instead of dividing the sum of Dow prices by 30, you would divide them by today's .132129493 divisor. The divisor helps statisticians avoid Dow value distortions, as it allows for stock splits and periodic changes within Dow components.

The Dow is a price-weighted index, as opposed to the Standard and Poor's 500, which is a market-weighted index. Within the S&P 500, the largest U.S. companies according to market capitalizations, feature the heaviest weightings. For the Dow, however, the highest priced stock carries the most influence over the index. Stock price, when taken by itself, is arbitrary.

For example, IBM trades for $195 and is the most dominant stock within the Dow. In terms of market capitalization, IBM is worth $225 billion. Alternatively, Exxon (NYSE:XOM) shares trade at $82, although the corporation is valued at $385 billion. At Dow 12,500, IBM, the smaller corporation, accounts for 1,475 points ($195 / .132129493 = 1,475), compared to 620 ($82 / .13212943 = 620) for Exxon. Dow value discrepancies are more so a matter of "we have always done it this way" tradition.

At $570 a share, the Apple Corporation would overwhelm the Dow Jones Industrial Average. At these levels, Apple would have added at least 4,000 points to the Dow today, if it had of been included at any point during the 2000-2010 Lost Decade.

Certainly, a record Dow 17,000 does not match the realities of today's U.S. economy that struggles with job creation.

The U.S. Economy

Apple has built its empire upon the strength of an integrated, closed circuit network of goods. Right now, Apple operates beneath the halo effect of "cool," as it hawks iPod, iPhone, iPad, iMac, and MacBook technologies to the "in" crowd. Consumers are happily paying up to participate within this counterculture movement, as evidenced by Apple's obscene 40-percent gross margins. Apple obviously markets discretionary inelastic product, which generates sales irrespective of prevailing economic conditions.

For bulls, Apple's track record is the mark of longstanding innovation. For bears, the outrageous numbers coming out of Cupertino are symbolic of a fad that will crash and burn, in similar fashion to the Research in Motions, Starbucks, and Cienas of yesteryear. Only time will tell.

In either case, I do not believe that Wall Street Journal executives responsible for putting together the Dow Jones Industrial Average would set a precedent by including volatile discretionary dollars within this historic index. As a leading economic indicator, it is critical that Dow component sales are either commoditized or cyclical in nature. Certainly, Microsoft (NASDAQ:MSFT), Caterpillar (NYSE:CAT), Home Depot (NYSE:HD), Exxon, and Bank of America (NYSE:BAC) profits represent larger cross sections of the economy, than a corporation that associates best with hipsters, celebrities, and teenage girls trying to be "cool."

Although a splendid aside, I would never mistake Apple iTunes with the word "Industrial."

Splitting Apple Stock

Proponents for Apple's inclusion within the Dow, of course, must also be ready to assume the pro-split crowd position. For Apple to be a viable Dow candidate, management might consider authorizing a 10-for-one split. This means that investors who own one share at $570 will own ten shares at $57, after the split. A stock split is merely cosmetic, as the size of all Apple positions and valuation methodologies will remain the same. At $57, there is much less chance for Apple shares to grow significantly into a triple-digit nominal amount, and skew the Dow Jones price-weighted average.

An Apple stock split, of course, would bring new issues to the table in Cupertino. According to a study authored by Dan W. French and David A. Dubofsky for the Journal of Portfolio Management, share price movements become increasingly volatile, after a stock split. Further, Chun-nan Chen and Chunchi Wu of Syracuse University argue that volatile prices signal that smaller, less sophisticated investors have taken on positions after stock splits.

Beyond simply attracting long buyers, we must also reason that a 10:1 split in Apple stock would also trigger hyperactive options activity, because one options contract carries price claims over 100 shares. Options traders would therefore enjoy much more flexibility with Apple at $57, instead of $570. This flexibility would not exactly be welcome, as options traders would steamroll the market before expiration to buy and sell Apple stock - to make good on positions gone bad.

For long-term investors, an Apple flash crash against a backdrop of earnings related panic, novice investors, and automatic options program trading would be disastrous. Imagine pulling the trigger on a market order to cash out and buy your dream Pacific Coast Highway home - at the very moment that some black swan event precipitates a 10-percent drop in Apple shares.

The Bottom Line

Although inclusion within the Dow would be an honor, I do feel that Apple shareholders are better off alone. Apple stock provides solid long-term value, because the company trades at 14 times trailing earnings and carries $120 per share in cash and investment securities on its books. Short-term traders working the Dow component story for fast profits are likely to be disappointed. Apple is no Dow Jones Industrial stock.

Disclosure: I am long AAPL, XOM.