One thing they don’t know, and don’t care to know, is what companies are worth.
For investors who want to buy low and sell high, that’s worth keeping in mind.
Introducing the Index Committee
You can live a happy life without ever wondering how the Dow Jones Industrial Average is produced. People take it for granted, like brown shoelaces or tap water.
But the Index Committee at a company called S&P Dow Jones Indices labors over which companies to include in the Dow. They recently decided to boot three companies and replace them with three others.
Out went ExxonMobil, Pfizer and Raytheon Technologies. In came Salesforce.com, Honeywell and Amgen.
Here’s a funny thing: An article in The Wall Street Journal points out that if history is any guide, an investor should buy the stocks being kicked out and sell the ones being included.
You Should Buy What the Committee Sells?
The members of the Index Committee don’t much care whether the stocks they include are cheap, reasonably priced or expensive. Their goal is to make a list that represents the leading companies in the US economy.
But they have other aims, too.
Their choices show that Committee members like stocks that have gone up over the past few years and dislike laggards. They are embarrassed when their index doesn’t do as well as others. Their company earns revenue from licensing the name of their index, so they want it to be popular.
Lately, the Dow has had returns that are lower than the S&P 500. The S&P has a bigger weighting in tech stocks, and these have been the darlings of the market. So, in me-too fashion, the Index Committee decided to add more tech stocks to the Dow.
Reversion to the Mean
But here’s where something called “reversion to the mean” comes in. Adding a stock that has already gone up often mean paying top dollar. Kicking out laggards often means selling what is cheap.
Over time, the price of a stock reflects its value as a business. Excitable investors may send a stock higher than its business value for a time, but the price will eventually come back to earth. Stocks that are priced below business value will rise.
Can we find reversion to the mean in the decisions of the Index Committee? A study by the Economics Department at Pomona College says yes.
An investor who bought stocks that were kicked out of the Dow would have done far better than one who bought stocks that were newly added.
A Popularity Contest That Can End Abruptly
Reversion to the mean doesn’t happen on a regular schedule. Prices are sometimes the result of a popularity contest rather than a rational appraisal of business value.
It can be tempting to think, “Well, then, let’s just buy the group that is going up today.”
But momentum is unpredictable. It can end abruptly. Those who blindly assume that prices will keep rising can lose a lot, very quickly.
Learn more about our approach to Investment Management. For a detailed look at how we analyze stocks, see “How to Find Good, New Stocks: Our Three-Part Test.”
Barry Dunaway, CFA®
America First Investment Advisors, LLC
This post expresses the views of the author as of the date of publication. America First Investment Advisors has no obligation to update the information in it. Be aware that past performance is no indication of future performance, and that wherever there is the potential for profit there is also the possibility of loss.