Corporate breakups could act as catalyst to changes in Dow index

Two components of the Dow Index, DowDuPont Inc and United Technologies Corp are breaking up into smaller companies providing an opportunity to add fresh blood into the index.

Although the composition for the Dow Jones Industrial Average has largely been left untouched, it could however undergo some change since 2 of its 30 constituents prepare to transform from large conglomerates into smaller companies.

Chemical giant DowDuPont Inc, is breaking up into three publicly listed companies, in which the first step, the separation of the company’s Dow materials science division, will take effect on April 1, 2019.

Industrial conglomerate United Technologies Corp, another index component, is also in the process of breaking up into three companies, in possibly in a year’s time.

“While many professional investors prefer other stock gauges to the Dow, membership in the blue-chip index – often thought of as Main Street’s market barometer – still carries allure because of its relatively few constituents. Funds with billions of dollars under management are also linked to the index, so constituent changes affect flows into and out of stocks” reads a report from Reuters.

According to market watchers, these changes, albeit small, could however, spur the overseers of the index to add fresh blood.

“All of the options are certainty on the table,” said Todd Rosenbluth, head of ETF and mutual fund research at CFRA. “This could be a catalyst for a new addition to the broader index.”

According to Ray McConville, spokesman for the S&P Dow Jones, the company will make an announcement before April 1.

“S&P DJI will review the index and make any necessary changes and issue a public announcement before the transaction takes place,” said McConville.

The S&P Dow Jones index is a measure of the performance of 30 companies which provide representation of sectors, other than transportation and utilities; these two are covered by other Dow Jones indexes.

Incidentally, the overall level of the Dow does not change when its components do, because the divisor used to calculate the index is adjusted.

Stock selection is “not governed by” quantitative rules, according to the published methodology, which also states that “a stock typically is added only if the company has an excellent reputation, demonstrates sustained growth and is of interest to a large number of investors.”

Given the subjectivity of the criteria, investors and analysts regularly speculate on which companies may qualify to be added to the index.

Some companies, that are likely to be obvious candidates, may have strikes against them.

Case in point: although share prices of Amazon.com Inc and Alphabet Inc are both well over $1,000 each, their inclusion in the index is unlikely since the high prices of their shares would warp the Dow, whose constituents carry more weight the higher their share price. At around $375 a share, Boeing Co’s shares is the highest priced stock in the Dow by more than $100.

Many indexes, including the S&P 500, are weighted by market capitalization, rather than by share prices.

One remaining piece of DowDuPont – the only materials sector stock in the Dow – could stay in the Dow Jones index.

“If you take DowDuPont off, then there is nothing really with that materials” exposure, said James Ragan, director of wealth management research at D.A. Davidson in Seattle. “I am not sure this is an opportunity to make a big change here.”

The DowDuPont breakup will leave Dow, specialty products company DuPont and Corteva, which focuses on agriculture.

According to Aleksey Yefremov, an analyst with Nomura Instinet, Dow and DuPont would be the biggest of the three, with market values estimated at about $50 billion and $60 billion, respectively.

“If they want to have a materials company they have to pick one of these two, just because they are so broad,” said Yefremov.

United Tech is breaking up into an aerospace supplier, an elevator manufacturer, and a provider of building products including air-conditioning systems.

Although aerospace is by far the biggest division of the three, by sales, however given the inclusion of Boeing, an aerospace stock, in the Dow, the inclusion of United Tech’s aerospace business will be redundant.

According to Lipper research, many investors and analysts view the S&P 500 as a more important barometer to the Dow Jones, given its 500 constituents weightage by market value. A little more than $23 billion is invested in mutual and exchange-traded funds tied to the Dow Jones Industrial Average compared to nearly $4.3 trillion tied to the S&P 500.

The Dow, a 120-year-old index, however remains a popular market gauge.

“The Dow’s price-weighted construct and the fact that it’s only 30 names makes it reasonably distinct from measures that folks will more likely look at to be representing the market as a whole,” said Simeon Hyman, global investment strategist at ProShares, which has five ETFs with $1.5 billion linked to the Dow. “The fact that it’s distinct means that some folks will find utility in it.”

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