Changes in the Dow - Babson College

12/9/2013

Changes in the Dow

An Event Study

Written By: David Abers Alex Goldman Justin Laurenzo Gregory Reichardt

FIN 3560

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Table of Contents:

Executive Summary ................................................................................................. 2 Introduction ........................................................................................................... 3 Procedure ............................................................................................................ 6

Event Studies............................................................................................... 6 Assumptions ............................................................................................... 7 Identifying the Event ..................................................................................... 7 Collecting the Data ....................................................................................... 8 Measuring Cumulative Abnormal Returns ............................................................ 8 Significance ............................................................................................... 10 Analysis .............................................................................................................. 10 Overview ................................................................................................... 10 Overall Impact ............................................................................................ 11 Added Stocks ............................................................................................. 12 Removed Stocks .......................................................................................... 12 Actual vs. Benchmarks .................................................................................. 13 Significance ............................................................................................... 14 Conclusion .......................................................................................................... 14 Works Cited ......................................................................................................... 16 Exhibit ............................................................................................................... 18 Appendix ............................................................................................................ 20 Waiver ............................................................................................................... 54 Babson Honor Code ................................................................................................ 54

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Executive Summary

The Dow Jones Industrial Average, upon its creation in 1896, has been important in the financial sector in an attempt to gauge the strength of the economy. Charles Dow, the creator, chose twelve stocks that he believed were representative of the backbone of the economy. Today's investors still watch the Dow Jones Industrial Average carefully to gauge the strength of the economy even though the index has increased its portfolio to thirty equities. Being added to the Dow Jones Industrial Average shows that the company is one of its industry leaders. Being removed from this index, however, does not mean that the company is not a quality investment, but rather demonstrates that their company is not as strong of an indicator of the country's economic health as other competitors.

The group conducted an event study centered on the announcement date of being added or delisted to the Dow with the goal of analyzing its effect on the company's returns in the short term. Logically, one might conclude that stocks being added to the Dow should see an increase in their returns due to the positive publicity associated with being added to such a prestigious list, while the delisted stocks should see a decrease in their returns due to negative publicity. However, several studies have shown that the opposite is true: delisted stocks actually perform strongly over a long-term period of around five years.1 Lastly, being added or removed from the Dow could have no significant effect on a company's returns, as being added or delisted from the Dow does not fundamentally change anything about the company: the honor is just a title of recognition.

In order to achieve our goal, the group calculated thirty-three cumulative abnormal returns to see if the announcement date had an effect on the company's short term returns. The cumulative abnormal return is the difference between the expected return on a stock and the actual return. The analysis entailed calculating the expected returns using held-back data, calculating the cumulative abnormal returns, and using statistical analysis to test for the significance of our data. If our data proves significant, our analysis regarding the effects of the announcement of a company's addition to or removal from the DJIA on its

1 Dow Exiles Often Have Last Laugh

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returns can be used when making investments going forward. If proven insignificant, being added or delisted to the Dow Jones Industrial Average has no effect on a company's returns.

Introduction

The Dow Jones Industrial Average, also known as the Dow Jones, DJIA, or the Dow, is the oldest major equity benchmark index in the United States. It was first founded on May 26, 1896 by Charles Dow, and originally consisted of twelve stocks. The Dow is a price-weighted index, which, since 1928, includes thirty of the nation's most prominent companies, mostly representing each major sector of the economy2. The DJIA specifically tracks how thirty large, publically owned companies have been trading during a period or standard trading session. Overall, the Dow provides a snap-shot of how both the stock market and the American economy as a whole are doing on a daily basis3. All of the stocks in the DJIA are traded on either the New York Stock Exchange (NYSE) or the National Association of Securities Dealers Automated Quotations (NASDAQ). Nearly 66% of the companies in the Dow are manufactures of industrial and/or consumer goods, such as Nike (NKE) and Wal-Mart (WMT).

One of the major reasons that this index has become so important over the years is because the United States is the largest economy in the world, and economies have become increasingly interconnected as technology continues to improve. Since the DJIA provides a reflection of how the United States' economy is performing, people are particularly interesting in tracking the performance of the country's most famous index.

Despite the Dow's major role as a measuring stick for the stock market and US economy, this was not always the case. For over twenty-five years after its induction, it was predominantly viewed by readers of the Wall Street Journal. It was not until the "roaring twenties" that the DJIA began to really become a staple for those who followed the market. After the crash in the late 1920s and early 1930s, instead of tracking each and every stock, media outlets began to reference the Dow to track the overall big-picture of the stock market's performance. With the beginning of the internet era and the turn of the

2 JSTOR, The Dow Jones Industrial Average Re-Reexamined 3 Foundations for Living

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century, the Dow has only become more prominent in the marketplace, especially in crisis periods. Post September 11th and the most recent financial crisis, the general public focused their attention on the Dow's performance, as it is a key indicator of the overall market's action. Today, there are few, if any, financial news sources that do not reference or publish information on or from the Dow Jones Industrial Average.4

When the Dow Jones was initially calculated, it contained a mere twelve stocks, only 1 of which still remains today: General Electric (GE). Upon its introduction in the late 19th century, the index stood at 62.76 points. To put this number into perspective, this year the Dow has soared to 16,174.50 points5. The reason for such growth is because of how the index is calculated. At first, calculating the DJIA was quite simple: take all of the stock prices, add them up, and divide this total by the number of stocks in the index. However, due to stock splits and stock dividends, which are very prevalent today, it has become much more complicated to calculate the average. The price of every stock in the index is still added up, but instead of dividing this number by the number of stocks in the index, it is divided by the "Dow divisor." Whenever a stock leaves or enters into the Dow, the divisor will change to reflect the new stock prices. According to Wall Street Journal, the divisor currently resides at 0.15571590501117. The Dow is a price-weighted index, so the more expensive stocks in the Dow have a greater effect on the overall average because they have more influence than the lower priced stocks. For example, International Business Machines (IBM-177.09) price changes will have a greater effect on the average than those of Cisco Systems (CSCO-21.17) because it is nearly 7 times more expensive.6 Each and every stock in the Dow has a different weight by price as well as weight by float-adjusted market cap.7

Since the DJIA is comprised of thirty of the strongest companies in the United States, the addition and subtraction of companies from the index is important and quite rare ? happening only a few times per decade on average. Perhaps the most important reason for the lack of changes is because the

4 Dow Jones Indexes, 5 Questions About the Dow That You Always Wanted to Ask 5 6 Yahoo Finance, Components for DJI 7 Exhibit 5

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