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  Seven months after the Dow's facelift, things have not quite worked out as planned, our contrarians say.

BENJ GALLANDER and BEN STADELMANN

Saturday, June 10, 2000

On November 1, 1999, the venerable Dow Jones industrial average received one of the biggest makeovers in its history. The index was lagging the performance of the Standard & Poor's 500 index, and Wall Street Journal senior editors Paul Steiger and John Prestbo trolled about for a new economy injection.

These guardians of the century-old Dow index (the Journal and the index are owned by Dow Jones & Co. Inc.) say they strive for continuity and stability, but the pace of change has accelerated markedly in the past 20 years. There were no changes between 1939 and 1956. After a long period of stability, the index of 30 blue-chip stocks has been revamped six times since 1980.

This time, the changes were more profound. For the first time, two stocks that do not trade on the New York Stock Exchange were added to the Dow index: the so-called Wintel combination of Intel and Microsoft.

Retailer Home Depot was also added, as well as AT&T progeny SBC Communications. Three of the retired stocks were veterans: Union Carbide, Goodyear Tire, and Sears, members of the index for more than 60 years. Oil giant Chevron was also removed.

This latest update was generally well received by analysts, who concluded that the changes were overdue and urgently needed to keep the Dow relevant in the 21st century. All of the new arrivals had stellar track records, up a sizzling 628 percent on average in the previous five years. As for the replaced firms, three were smelly industrials in decline, and the fourth an apparently tired and uncompetitive retailer.

In 1997, in another major realignment, Westinghouse, Texaco, Bethlehem Steel and Woolworth were tossed in favour of Travelers Group (now part of Citigroup), Hewlett-Packard, Johnson & Johnson and Wal-Mart. The new quartet has performed very well, up an average of 166 percent, easily outpacing the entire index, which posted a gain of 55 percent in the same period. Obviously, last time up, the Wall Street Journal editors hit a home run.

This time, however, things are not working out as well. SBC Communications has had difficulty getting traction and is down 11 percent since its debut in the Dow. Microsoft's well-publicized problems with the U.S. Justice Department have chopped 25 percent off its value. But the stock that has done the worst is Home Depot, down 34 percent.

The home improvement icon's spectacular growth has eased off, and investors are rethinking its rich price-earnings multiple. A profit warning by another big-box contender, Costco, has also rippled through the industry.

Curiously, one retailer that has held its own is good old Sears. It's up more than 36 percent since November, and has posted some solid sales numbers this spring.

First-quarter earnings were up 71 percent compared with a year ago, and investors were impressed with the company's increased ability to take on not only Wal-Mart, but also the new e-business retailers as well.

Of the new entries, only Intel has kept its previous all-star form. The chip maker is up a startling 66 percent since it joined the team.

The key thing for investors to remember is that stock indexes are not the objective yardsticks their proponents make them out to be. Instead, they represent proprietary model portfolios, and their owners make money by licensing the indexes to the mutual funds that build investment vehicles around them. The better an index performs, the more likely it is to attract investment capital, so there is pressure on the index-keepers to tinker with the lineup, like a sports general manager always on the lookout to improve the team.

Then there is a question of how the index is computed. In the case of the Dow, it is a price-weighted average. This means that a 5 percent gain in a pricey stock like JP Morgan will add about 35 points to the Dow, but the same percentage rise for Phillip Morris would add only 7 points.

Or take the example of General Electric: its recent three-for-one stock split means its influence on the Dow has been cut by two-thirds, yet the company has once again passed Microsoft and Intel for the crown of the world's most valuable corporation.

If all this seems very arbitrary, it is, but the common alternative of indexes weighted by market capitalization, like the Toronto Stock Exchange 300 composite, entails a different set of problems. We'll take a look at those in a future column.


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