Mr. Dow And Mrs. Jones - Welcome To Stock Picking

Summary

• This article was written by Bruce Kaser, head of equity research for New Generation Research, publisher of George Putnam III's The Turnaround Letter.
• Only two days after joining the Dow Jones Industrial Average, Walgreens Boots Alliance fell 10%, as Amazon is entering the pharmacy business with its PillPack acquisition.
• This might not have been the effect that the S&P Index Committee had in mind when it chose Walgreens to better measure the economy and the stock market.
• Indices are seen as representing "the market", but they are baskets of individual stocks with all the risks these stocks bring.

Well, that was fast. Last week, the S&P Index Committee removed down-trodden General Electric (GE) shares from the venerable Dow Jones Industrial Average. Two days later, shares of its replacement, retail pharmacy company Walgreens Boots Alliance (WBA), fell a brisk 10%.

The cause: a very company-specific problem for the new Dow member as Amazon (AMZN) has acquired PillPack, an online company that provides home-delivery of pre-sorted medications. This could make Walgreens the next company to see its profits eroded by the Internet giant. For reference, GE shares were down less than 1%.

Becoming the next e-commerce victim might not have been the effect that the S&P stock-pickers had in mind when they chose Walgreens to "make the index a better measure of the economy and the stock market." Perhaps they should have selected Amazon instead?

Indices like the Dow Jones Industrial Average are seen as representing "the market." As such, most investors assume they have essentially zero risk from the effects of individual stock prices. But in reality, these indices are baskets of specific stocks - that is what makes up the market. And, when a highly concentrated index like the DJIA holds only 30 stocks, its exposure to any one stock's fundamentals and valuations, not to mention investor sentiment, can have a meaningful effect.

When the S&P Index Committee makes changes to its portfolio, they are picking stocks. Like many investment committees, they meet on a regular basis (monthly) to review their holdings based upon a specific methodology ^1. As stock-pickers ourselves, who spend significant amounts of time researching and valuing individual stocks, we fully appreciate the merits and difficulties of deciding which to buy and which to avoid.

So, when the Dow Jones, or any index, has a rough day, it might just be that a few prominent stocks had company-specific problems. It may not be "the market" after all.

1. For the S&P Index Committee’s methodology, please visit their website at this link. http://us.spindices.com/documents/methodologies/methodology-sp-us-indices.pdf

Disclosure: I am/we are long GE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.