Changes in the Dow - Babson College

[Pages:55]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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Dow believes that constantly modifying the index's complexion alters the very nature of the index itself.8 That being said, there have been a total of 53 changes since the Dow's induction in 1896. The most recent change was made this year on September 20, 2013, when Goldman Sachs, Nike, and Visa replaced Bank of America, Alcoa Incorporated, and Hewlett Packard Company, respectively. The main reason that such changes occur is because a stock price has gone lower than expected. In the most recent change, the chairmen of the index committee, David Blitzer explained: "We are removing three lowest-priced stocks and replacing them with stocks with higher prices." Again, the correlation between a stock price and the impact on the index is direct: the higher the price of a stock, the higher its impact will be on the index. Companies are also added and removed to take into account sector representation. Sector representation means that certain companies will be added or removed to represent their various industries, such as the consumer sector, technology sector, investment banking, and many others. In the recent change, Nike will represent the consumer sector, Visa will represent the technology sector, and Goldman Sachs will represent the investment banking sector. With this change, the Dow is losing an industrial company in Alcoa, as neither Nike, Visa, nor Goldman Sachs is in the same industry as Alcoa. In rare situations, a company is forced to leave the Dow due to bankruptcy, or government ownership. During the financial crisis in 2009, General Motors (GM) and Citigroup (C) were forced to leave the Dow for both of these reasons. General Motors filed for bankruptcy and Citigroup became partially government-owned, giving up 34% of their equity to the government. The removal of General Motors was a huge deal for both the company and the index because at the time, they had been in the Dow for all 83 years without interruption.9 With each and every company that is either added or subtracted from the Dow, it certainly makes headlines.

There are also various indices, some even larger than the Dow. The S&P 500 is a stock market index just like the Dow, but consists of 500 different companies from all different sectors of the

8 Dow Jones Indexes, 5 Questions About the Dow That You Always Wanted to Ask 9 Wall Street Journal, Travelers, Cisco Replace Citi, GM in Dow

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economy.10 Just like the Dow, it is closely followed and depicts the American economy's progression. Although several of the other indices in the United States contain many more companies than the Dow, they are both performing about the same.11 According to correlation tables (1 represents perfect correlation), the relationship between the DJIA and other Major U.S Indices is nearly the same, meaning that although the Dow contains fewer companies, its performance is still in line with these other respected indices.12 The Dow Jones also has other more industry-focused indices, such as the Dow Jones Transportation Average and the Dow Jones Utility Average. The Dow Jones Transportation Average only consists of stocks from the transportation sector. Likewise, the Dow Jones Utility Average solely consists of fifteen prominent utility companies. There is no doubt that the Dow has competitors, but because some of them consist of such a high number of stocks, such as the S&P 500, the Dow is much easier to follow and actually depicts the same picture of the economy as do these larger indices.13

Overall, the Dow Jones Industrial Average is the most important index in the world and is followed on a minute-by-minute basis. The prices of the stocks and the DJIA represent general market trends and give an overall view of how the economy is performing on a daily basis. Whenever someone asks how the market is doing, the first thing to look at would be how the DJIA is performing at that moment. If the index is up, then the markets are performing well and vice versa. The largest drawback of the Dow is that it only tracks 30 stocks. This is why some people prefer the S&P 500 because it includes 500 companies as oppose to just 30.

Procedure

Event Studies The group conducted an event study to compare the differences in how equities react when added

to or delisted from the DJIA. An event study is used to "assess the impact of an event," which in our case was the day an announcement was made that a stock will be added or delisted from the DJIA. The

10 CNNMoney, S&P 500 11 Dow Jones Indexes, 5 Questions About the Dow That You Always Wanted to Ask 12 Exhibit 6 13 Dow Jones Indexes, 5 Questions About the Dow That You Always Wanted to Ask

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analysis looks at each company that was added or removed from the Dow between 1997 and 2013, totaling thirty-four changes: seventeen added and seventeen delisted. However, in our analysis for delisted stocks, GM was removed from the data, because upon defaulting on its debt and filing for bankruptcy, it did not have sufficient information required for the analysis. As a result, the total number of companies in the event study that were removed from the Dow fell to sixteen. There are four basic steps in an event study: identifying the event, collecting the data, measuring cumulative abnormal returns, and analyzing the results.14 Assumptions

There are several key assumptions that must be made when conducting an event study: markets are efficient, the event is unanticipated, and there is an absence of "noise" during the event window. Before deciding to fully use event studies to measure the change in DJIA, the group had to address each of these assumptions. First, since the market did not collapse and traded consistently through the time period our group analyzed, the team was able to satisfy the assumption that the market is efficient. Second, our group used the announcement date in order to be able to assume that the event was unanticipated. Third, the absence of noise meant that when analyzing the data, our group had to assume that the event itself was the only factor affecting the abnormal returns. If we analyzed the data using another method, we would have been able to take into account other influences, such as the interest rate, political turmoil, trade agreements, and other economic factors. Identifying the Event

For this analysis, the event in question could be either the announcement day or the day of the change itself. The announcement day is when the DJIA officially stated that the stock will be added or removed. The day of the change would be the date in which the stocks were in fact added or removed from the index, subsequently requiring a change in the divisor. Had the group looked at the day of the change as the event in our study, the event would obviously have been anticipated, as the markets would have had several days to react to the announcement.

14 Event Study Method PowerPoint

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