Why Stocks Do Better After Getting Kicked Out of the Dow

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Getting booted out of the Dow a year ago may have been a blessing in disguise for ExxonMobil  (XOM) – Get Exxon Mobil Corporation Report, Raytheon Technologies  (RTX) – Get Raytheon Technologies, Corp. (RTX) Report, and Pfizer  (PFE) – Get Pfizer Inc. Report.

In the year since, each of these three has far outperformed the stock that replaced it, as well as outperformed the market as a whole. On average, they have gained 41.6% since being removed from the DJIA on Aug. 31, 2020, versus just 8.2% for the three stocks that replaced them (Salesforce.com  (CRM) – Get salesforce.com, inc. Report, Honeywell International  (HON) – Get Honeywell International Inc. (HON) Report, and Amgen  (AMGN) – Get Amgen Inc. Report, respectively). The comparable return for the broad market as a whole is 28.8% (as judged by the S&P 500’s total return).

Over on Real Money, Bret Jensen notes that the beaten-down biotech sector just  had one of the best weeks in a year. The SPDR Biotech ETF  (XBI) – Get SPDR S&P BIOTECH ETF Report surged last week, helped by a multi-billion acquisition with a big buyout premium by Pfizer, which was putting some of Covid-19 vaccine lucre to work. Get more of his investing insights and trading strategies.

These relative returns are just the reverse of these stocks’ performances in the six months prior to Aug. 31, 2020. Ironically, that date came close to marking the peak of the added stocks’ popularity and the trough of the deleted stocks’ unpopularity.

Average return over six months prior to Aug. 31, 2020 Average return since Aug. 31, 2020

3 stocks added to DJIA on 8/31/2020

+30.6%

+8.2%

3 stocks deleted from DJIA on 8/31/2020

-7.8%

+41.6%

S&P 500 total return

+19.2%

+28.8%

I point this out not to enjoy a chuckle at the expense of the Dow Jones committee that decides which stocks should be part of the 30 in the Dow Jones Industrial Average. What happened to these six stocks over the past year is actually the rule rather than the exception.

The same is true, on average, for stocks added and deleted to the S&P 500 over the past seven decades. It would have been unusual if last year’s deletions hadn’t outperformed the additions.

Instead, the reason to point this out is to make a broader investment point about the importance of being a contrarian: The most popular stocks often prove to be disappointing performers. These stocks may represent entirely good companies, but even outstanding companies can find it difficult to earn as much as is necessary to support the lofty prices that result from investor enthusiasm.

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Out-of-favor stocks, in contrast, often proceed to perform well because their companies need only jump over a much-lower hurdle. In fact, out-of-favor stocks are able to outperform the most popular ones even if their companies are less profitable than the most popular ones.

To be sure, as I pointed out in my column a year ago discussing these additions and deletions, Dow Jones said that they were making these changes because Apple was splitting its stock four to one. Because the DJIA is a price-weighted index, this would have reduced technology stocks’ share of the index. So they needed to make changes to keep this sector’s share at an acceptable level.

I don’t doubt that this is why Dow Jones was prompted to make these changes. But, as a general rule, the stocks that are added will be more popular than the ones that get deleted.

Investors often overlook their ability to make more money with a less profitable company. My best analogy for making this point is to imagine being able to bet on any horse in a 10-horse race. Imagine further that one horse is the overwhelming favorite to win while another is expected to come in a distant last. Finally, assume that the favorite horse comes in second, while the horse expected to finish last ends up in 7th place. It’s entirely possible that you would make more money having bet on the horse than came in seventh than the one that came in second.

Notice that the seventh-place finisher is still the slower horse, even though you made more money betting on it. The same can be true when you bet on an out-of-favor stock.

One study whose results are relevant was conducted several years ago by Robert Arnott and Lillian Wu of Research Affiliates, titled The Winners Curse: Too Big To Succeed?

To conduct their study, the authors constructed hypothetical portfolios containing the No. 1 stock, by market capitalization, in each market sector; they referred to these stocks as “Top Dogs.” The researchers found that “59% of these Top Dogs underperformed their own sector in the next year, and two-thirds lagged their sector over the next decade.” The extent of underperformance was huge, furthermore, averaging between 3% and 4% per year.

How do you know if your portfolio is heavily loaded with the most popular stocks? Compare their valuation ratios to that of the market as a whole. If your stocks’ P/E or price/sales ratios are far higher than the markets, it’s a good bet that your stock selection approach is the functional equivalent of the decision Dow Jones made a year ago to add three and remove three stocks from the DJIA. Let these stocks’ relative returns since then be a reminder of the risks of betting on popularity.

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