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What Does Alcoa's Exit From Dow Jones Mean?
In the biggest shake-up of the index in nearly a decade, the Dow Jones Industrial Average (DJIA) has decided to remove Alcoa ( AA ), HP and Bank of America and replace them with Nike, Visa and Goldman Sachs. The changes will go into effect after the end of trading on September 20. The main reasons for Alcoa's eviction seem to be its low stock price and the company's diminishing role in an economy that has moved away from heavy manufacturing over the years. Also, Alcoa's market value of $8.5 billion is easily the lowest among DJIA companies.
Being dropped from Dow Jones is largely symbolic for Alcoa and is unlikely to affect its stock price meaningfully. The amount of money indexed to the DJIA is quite insignificant relative to the S&P Index or Russell 2000 so there won't be much offloading of Alcoa's stock by fund managers who track the index. Alcoa itself sought to downplay the eviction by saying that it will have no impact on its ability to execute its strategy. The company reiterated its commitment to delivering shareholder value.
Reasons For Alcoa's Exclusion
The DJIA is a price-weighted index, which means that the stocks with the highest share price have the greatest weight. The three companies which were removed from the index in the latest shake-up have single digit or low double-digit stock prices. Thus, movements in their prices don't impact the index as much as higher prices members like IBM and 3M. At a price of $7-8 per share, Alcoa is easily the cheapest stock in the DJIA. (( Alcoa, H-P, Bank of America kicked off Dow , The Christian Science Monitor))
According to the chairman of the index committee that decides the DJIA's composition, Alcoa, BofA and HP constitute just 3% of the index's value. For an index that has just 30 companies, the committee felt that it couldn't justify allocating three positions on the index in return for just 3% of the value.
The owners of the DJIA also wanted to diversify the make-up of the index to reflect the real economy. The economy has gradually shifted from heavy manufacturing to other areas like finance, healthcare and technology. The mining and materials sector, to which Alcoa belongs, constitutes just 3-3.5% of the overall U.S. stock market today. Also, aluminum consumption in the U.S., as a percentage of the overall Gross Domestic Product ( GDP ), has declined over the last five decades. While it represented 0.2% of the U.S. GDP in 1959 when Alcoa joined the DJIA, today it constitutes just 0.02%. This trend is mirrored in Alcoa's steadily declining share of the Dow, from 2% 10 years ago to 0.4% today. (( Alcoa Junk Downgrade Is Rare Trauma for Dow Stocks: Commodities , Bloomberg))
The index committee thought that the Dow had too few consumer discretionary companies and there was no apparel representation. This is where Nike, the company brought in to replace Alcoa, comes in.
What The Decision Means For Alcoa
While the DJIA is still closely watched as a barometer of the broader market, it has long ceased to have much tangible value among institutional investors. This is reflected in the data provided by Morningstar on the number and worth of funds tracking the DJIA and the more popular S&P 500 indices. While 1,323 mutual funds worth $2.9 trillion track the S&P 500, only six funds worth $196 million are pegged to the DJIA. Therefore, if Alcoa's stock is offloaded from the funds that have DJIA stocks in their portfolio, there may be short-term fluctuations in its price but the overall impact is unlikely to be significant.
Despite the low probability of significant financial implications, eviction from the DJIA is symbolic of an erosion in Alcoa's prestige over time. Overcapacity in the aluminum production industry and low prices resulting from it have reduced the company's heft, as indicated by the downfall in its stock price from $47 at peak levels in 2007 to $8 today. The stock price never really recovered from the economic crisis of 2008.
The volatility in aluminum prices has resulted in fluctuating fortunes for Alcoa, which is now trying to address it by targeting value-added product sales to the automotive and aerospace industries. In a statement issued as a reaction to the latest news, Alcoa talked about its focus on these two industries and its effort to optimize upstream competitiveness and costs. However, we think that the company will take considerable time to reinvent and re-position itself before it is able to regain its former glory.
We have a Trefis price estimate for Alcoa of $7.