FWIW # 8 Just the Facts September 2020

On Monday, August 31, 2020, the smoke and mirrors of Wall Street cleared somewhat and interested observers were able to confirm that true investing has nothing to do with what is taking place in the securities markets today. Here’s what happened.

The S&P 500 Revised

S&P Dow Jones Indices managers responsible for the composition of the thirty-stock Dow Jones Industrial Average (INDU) decided to change three stocks. They removed Exxon Mobil (XOM), Pfizer (PFE), and Raytheon Tech (RTX) to replace them with Amgen (AMGN), Salesforce (CRM), and Honeywell (HON). When looking at the changes, it’s easy to see an industrial company, HON, was substituted for an industrial aerospace company, RTX. A biotech company, AMGN, was substituted for a major pharmaceutical company, PFE. The only economic sector change was substituting a technology company, CRM, for an energy company, XOM. What led to these changes? If you listen to the index managers, it was because Apple (AAPL), formerly the highest-priced stock in the index, split its shares. Even though a stock split has no bearing on the total value of a company, the split did affect the INDU because the index is influenced by the actual share price rather than the company’s market capitalization.

S&P Dow Jones Indices will tell you the changes reflect changes in the economy. I’m sure there is a kernel of truth to their belief, but it’s hard to think energy will not be a major part of the economy for decades to come. The removal of XOM has the smell of political pressure from alternative energy and climate change advocates. Why? Because Chevron (CVX) is now the only energy stock in the INDU and represents just 2.5% of the index. Ten years ago, the energy sector accounted for 12.5% of the INDU. The other changes are in related sectors and industries. So, what’s the real reason for changing 10 percent of the index?

Why the Change?

The INDU managers have been disappointed in the relative underperformance of the index. They want more volatility. Volatility is what increases the amount of assets in the INDU index funds and ETF, which are the holy grail of the markets today—assets in ETFs. How can you have more volatility with a thirty-stock index? Easy: take out the laggards and put in three high-flyers. Forget the fact that specific relatively short-term factors may be influencing the laggards’ current stock prices. Let’s examine the three rejected companies.

XOM is the largest US-integrated oil company. The price of oil has been under pressure for a number of reasons: a) oversupply with the ramp-up of US production; b) the COVID-19 virus, which instantly reduced the demand for oil, particularly in the air transport business; and c) the global recession stemming from the COVID-19 shutdowns. Any one of these factors can reverse itself in the next eighteen months, giving way to an improving global economy exerting upward pressure on energy prices. The probabilities of energy prices staying where they are for two, five, or ten years is low. The current price of XOM and other high-quality energy companies with oil reserves in the ground does not reflect any improvements in oil prices.

PFE is a full-spectrum pharmaceutical company. It’s in the midst of a major restructuring transaction, merging its non-prescription consumer businesses with Mylan Labs (MYL), a generic drug maker. This deal has been in the works for several months and is a factor in the relatively stable price of its stock due to arbitrage between the old PFE shares and MYL. When the deal is done, the current hedges will be unwound by speculators and the price of PFE will no longer be artificially suppressed. PFE will be a pure research pharmaceutical company with a major COVID-19 vaccine in partnership with a German biotech company. The PFE business remaining may have a higher price-to-earnings ratio, but the number of shares will remain what it is now.

RTX is another interesting removal. It’s the product of a recent merger between United Technologies (UTX), an industrial/aerospace company, and Raytheon Corp (RTN), an avionics and missile technology company. Unfortunately for the merger strategy, the COVID-19 virus changed the near-term outlook for the company. Even so, its share price has dropped only to the middle of its range rather than spiraling to new lows. This new company has a premier position in the defense, industrial, and aerospace industries. Will it take longer for the synergies and promises of this merger to come to the forefront? Of course, unless a turn of events causes an upswing in these industries. Either way, the current valuation is far better than it was when the stock price was much higher.

Now, let’s look at the three companies being added to the INDU. The first is CRM, which is the leading software company for client relationship management. Since the other changes in the INDU are in similar industries, and definitely in the same economic sectors, this switch to CRM from XOM was clearly a decision to change the economic and volatility profile of the INDU. The index has been underperforming relative to the other major indices for some time, and the managers indicate they believe the three changes will boost the INDU’s peer performance. CRM is a company with a historic market-relative volatility of 1.26 (the S&P 500 volatility number is 1, so CRM has been more volatile than the S&P 500). The stock’s performance for 2020 shows a price range of $115.29 to $284.50, with its price the Friday before Labor Day at $254.70, much more volatile than the S&P 500.

AMGN has been a leader, if not the gold standard, of biotech companies for over twenty years. It has a historical market-relative volatility number of .86, which implies it is less volatile than the S&P 500. This year, however, the stock has had a price range of $177 to $265, far greater than the S&P 500.

The third stock is HON, an industrial company that has performed well, but is not near the all-time high it reached in late December and early January. Nevertheless, its performance this year has been better than the S&P 500 even though its historical market-relative volatility number is only 1.03, essentially the same as the S&P 500 number of 1.

The INDU managers, trying to avoid a massive gap in the value of the INDU the day it opened with the three new components, changed the divisor by which they make their calculation for the index’s final value. By changing the divisor, they were able to replicate the past performance of the index, using the new stocks’ price history, so that past performance would have been essentially identical to what it was in reality. Pretty clever, eh?

All three of the stocks removed from the INDU are clearly not favored in the current marketplace. All three of the stocks added to the INDU are clearly favored in the marketplace. What does this mean?

Back to the Basics

Go to the internet and find the first-ever writings about investing, if you can. It’s clear the basic premise of investing, not speculating or gambling, is to buy low and sell high. There is no possible way this bedrock principle can be refuted. Now, look at what the INDU managers just did: they sold three stocks at or near their low (XOM, PFE, and RTN), while at the same time buying three stocks (CRM, AMGN, HON) close to their all-time highs. If an observer looks at the INDU as a portfolio, which they should, then it appears the managers just performed a classic mistake in a bull market: they bought high and sold low. A rookie mistake if there ever was. Why?

The only explanation is they are trying to increase the volatility of the INDU to attract more speculators to the ETFs and mutual funds that mimic the index. Fixing the divisor to “fit” the new index to the performance of the past index implies that the volatility going forward will be close to what it was in the past. That’s questionable, particularly on the downside. The managers took out three companies that were experiencing muted volatility while adding three stocks that were experiencing greater volatility than historically implied. In a downdraft of the market, instead of having three stocks that are stable, the INDU now has three stocks recently experiencing above-historical-market volatility.

What to Do Now

These changes in the INDU are a red flag, and not the only one. What should investors do? First, recognize the signals and start identifying the companies that will complement their portfolios when and if the markets take a tumble. Second, know where the share prices of the potential additions are good values. Third, when the market starts falling (don’t worry about 5% or 10%, think 25% to 35%), enter good-till-cancel orders for the potential additions. This way, when the fear in the marketplace becomes extreme, true investors won’t falter and fail to pick up some companies that round out and improve their portfolio and income.

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