Apple Should Be Added To The Dow, Hewlett-Packard Should Be Dropped

Aug. 2.12 | About: Apple Inc. (AAPL)

There has recently been some speculation that Apple (AAPL) is being primed for entry into the Dow Jones Industrial Average ("DJIA"), and the potential for such a move appears reasonable. Additionally, while it is true that the upcoming split of Kraft (KFT), a DJIA component, could allow for Apple to be added, I believe it is just as likely that another tech company would be dropped, and that the most appropriate company to drop would be Hewlett-Packard (HPQ)

Apple is presently valued at about $570 billion, and has a 4.42 percent weighting in the S&P 500 (SPY). At this size, it should be clear that apple is important enough to be included in the DJIA. Apple is larger than any of the current 30 constituents, with only half having a market capitalization of at least $100 billion.

One thing that all Dow Industrials do is pay shareholders a dividend. Since Apple will start paying a dividend this coming quarter, that condition will soon be met. Apple's yield will be about 1.7 percent, which is below average for the Dow Jones Industrial Average, but far from the lowest yield on the current index. Hewlett-Packard is now yielding nearly three percent, though much of the reason the yield got so high is because the company is currently valued at about half what it was one year ago. In that time, HPQ's quarterly dividend did increase from $0.12 to $0.13, though that is little solace to shareholders that have seen a decline in share price of about $17.50 in the same term.

Another step that appears necessary before Apple could join the DJIA is for it to split its $600-plus stock in a way that would appropriately size it for the index. Being in an index usually means keeping share prices reasonably low, and splitting them when they get too high. Just a few years back, when Berkshire Hathaway (BRK.B) was included in the S&P 500, it followed the company splitting its B-shares 50 to 1. In Apple's case, it appears a split of between 5 and 15 to 1 may be proper for its initial entry into the index.

While it may be true that Kraft is splitting and that this does create a position where the index could make a switch without kicking out a member, a transition from KFT to AAPL does not appear the best move. Kraft is a consumer goods company that sells packaged foods and is broadly considered a defensive company. Apple is a technology and communications retailer that represents a very different industry and sector of the market than Kraft.

Generally speaking, the DJIA does not like to distort its allocation. An example this came in 1985, when General Foods was bought-out by Philip Morris. Because General Foods was in the index, Philip Morris replaced it and became the second tobacco company then on the DJIA. As a result, the index decided to drop the other tobacco constituent, American Brands, and then add McDonald's (MCD) to the DJIA, which it concluded better balanced the average.

The DJIA currently holds numerous tech companies, with several of them dramatically underperforming the broader market over the last several quarters. Some of these current Dow constituents, including Microsoft (MSFT) and Hewlett-Packard compete with Apple. In many ways, HPQ's recent problems are due to Apple's recent success. As this trend continues, it makes HPQ less and less important to the economy, and also less representative of it. The one condition that may prevent such a switch being made, however sensible, is that the index is generally extremely reluctant to remove companies without a significant potential for a forthcoming bankruptcy, though exceptions do exist.

While you may hear many individuals complain of the Dow Jones Industrial Average that it does not adequately represent the total market, or that it is generally antiquated when compared to the S&P 500 and other broader indexing mechanisms, this is not necessarily true. The reality is that despite the S&P's having about 16.6 times as many companies as the Dow Jones Industrial Average has, the two averages have been very highly correlated for many years. In fact, over the last decade, the two have performed nearly identically.

See a 10-year chart comparing the S&P 500 to the Dow Jones Industrial Average: (click to enlarge)Click to enlarge

Over the last there years, since the market's bottoming out in the Spring of 2009, the correlation between these averages has been exceptionally high. See a 3-year chart, below: (click to enlarge)Click to enlarge

In both instances, the less diverse and antiquated Dow Jones Industrial Average outperformed the broader and modern S&P 500. Moreover, the DJIA has a higher yield (currently about 2.44% versus 1.93%), which means the DJIA has notably outperformed the S&P 500 in total return over the last ten years. Therefore, despite the S&P 500 being so clever as to add Apple many years ago, and to also add companies like Google (GOOG) and so many others, it has not subsequently shown any alpha compared to the DJIA.

Much of the reason for this is because markets are often zero-sum games, where a new winner means an old loser. In the case of Apple, the S&P 500 includes numerous competitors that have been hurt by Apple's success, including computer makers such as HPQ and Dell (DELL). Many other constituents have been destroyed by their peers over the years, such as Eastman Kodak, which was kicked out of the S&P 500 in 2010, about a year before going bankrupt. If anything, the high correlation between the S&P 500 and the DJIA, and mid-term outperformance of the DJIA, illustrates the dangers of over-diversification, and the potential for it to marginalize individual equity achievements.

If Apple were to be included in the Dow Jones Industrial Average, it would force more funds and institutions to acquire Apple shares, whether or not they think it is a good investment, simply because of its inclusion in the index. In the long run, it appears inevitable that Apple will be included in the Dow Jones Industrial Average, but whether or not it happens in the coming quarters is slightly less clear. Any forthcoming announcement of plans to split Apple shares may be seen as further prepping for such a move, and will likely have a positive short-term affect upon share prices.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.