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The Dow, the S&P 500, and Tesla’s New Home

When people start investing or relying on their portfolio to replace their paycheck in retirement, they typically begin watching the Dow Jones Industrial Average (Dow) to track the market and determine if their portfolio is doing what it should.

Since its creation in 1896 the Dow was intended to provide a good representation of the U.S. stock market, and the companies that make up the index are occasionally changed to keep it relevant.  This year Salesforce, Amgen and Honeywell were added to the Dow in August while Exxon-Mobile, Pfizer and Raytheon Technologies were removed.  But the Dow consists of only 30 companies, and even with these updates it’s unreasonable to expect it to reflect the investment performance of the entire U.S. market.

The value of the Dow is calculated each day by adding up the current share price of each of the 30 stocks, and then dividing by the Dow divisor, which changes due to stock splits and other factors.  This method can cause companies with a lower market capitalization to have a much bigger influence on the value change, and lead you to believe that total market returns are more positive than reality.

With these limitations it’s still the index quoted in news updates, and investors continue to be confused when the Dow is up 3% one day and their own portfolio isn’t.  So, the next index you might consider for a more representative view of the U.S. market is the S&P 500.

The S&P 500 has an immediate advantage over the Dow because it consists of 500 vs. 30 companies.  It also uses a market capitalization weighting, so a company with a high stock price and a large number of outstanding shares will have a bigger influence on the index changes than a lower priced one with fewer shareholders, which seems more logical.

A committee selects the companies included in the index and evaluates its representation of the market frequently to determine if changes should be made.  There are a number of different criteria a company has to meet to be included in the index, including size, liquidity and profitability.  With a larger number of companies included and the requirement that each company have a market capitalization of $8.2 billion or more, the index captures the majority of the U.S. market as can be seen in the chart below, but it still leaves another 16% of the market behind, including real estate investment trusts and thousands of smaller companies.  If you have a diversified portfolio that includes small companies and real estate investment trusts, using the S&P 500 as a benchmark for your portfolio performance will cause disappointment in years when small companies lag large ones.  And you may even conclude you are better off in larger, more visible companies.  But shifting your investments that direction means you may miss out on the next Apple, Amazon or Google that’s still in it its early stages of growth.

At TAAG, we construct portfolios to include both small and large companies, real estate and international companies because we know that investment returns come from variety of places, not just the largest U.S. companies.  And being tied to just large companies, or investing by simply holding a large, U.S. company index fund that tracks the S&P 500 can have drawbacks.

As you may have heard, Tesla is being added to the S&P 500 Index before the market open on December 21st.  The company’s stock price has gone up significantly this year, and as a result its inclusion in the S&P 500 index means that it will immediately be the 6th largest company in the index, jumping ahead of Berkshire Hathaway and just behind Facebook.

Due to its jump in size this year some investors were advocating for adding Tesla in a two-step process, for a smoother transition.  But the committee decided against it, and with its history of large price swings its inclusion is expected to make things very difficult for managers of S&P 500 Index funds and ETFs that track the S&P 500 as they attempt to add the company into their holdings – when all other S&P 500 managers must buy the same stock – without paying ‘too high’ a price.  As we’ve shared in our blogs, meetings and discussions with clients, the DFA Funds we utilize in our portfolios do not follow the strict timeframes for deletions and additions that some index and ETF managers must follow, allowing them to obtain better pricing and, ultimately, better expected returns.

In July, Tesla’s share price made it the most valuable car company on the planet.  It’s valuation at that point put it higher than Fiat, Fort, Ferrari, General Motors, BMW, Honda and Volkswagen – combined.  Its total market capitalization surpassed Toyota, which produced 2.4 million vehicles in the first quarter of 2020, compared to Tesla’s 103,000.  Obviously, some people are very enthusiastic about the future of the company, which has driven its price to earnings ratio to 1,250.10 as I type this blog.  Compare that to the Dow’s 29.39, the S&P 500’s 41.52 or the NASDAQ 100 technology-focused index P/E ratio of 38.21.

And while some may feel that they have missed a great opportunity with Tesla, there is something to be learned from history.  Yahoo’s market capitalization peaked less than a month after it was added to the S&P 500 in 1999 – just before the burst of the dot-com bubble.  Qwest Communication’s market cap peaked the same day it was added to the index in July 2000.

Neither stock trades today.