Ringling Brothers And The Dow
I was saddened (but not surprised) about the recent news that Ringing Brothers and Barnum & Bailey Circus is shutting down after 133 years. The circus was formed by the Ringling family in Wisconsin in 1882. It merged with the Phineas Barnum's circus in 1884 and became a cornerstone of Americana for generations.
I recall seeing the Ringling Brothers circus as a kid and we enjoyed taking our daughter Abby to see it as well – good solid family entertainment.
Cash flow troubles due to high operating costs, changing consumer tastes and hectoring from animal rights groups all have been cited as adverse business factors that lowered the curtain on Ringling Brothers, but the back story is more revealing.
The phenomenal success of Cirque du Soleil suggests the circus entertainment genre is alive and well. Founded 1984, it is now the largest entertainment company in the world. It circus shows feature human-only performances and yet plays to packed houses around the world.
So the driving force behind the Ringling Brothers demise is more likely that it failed to adapt to a changing consumer market; their circus show genre became outdated over time and the company paid the ultimate price for bad management. Another object lesson for all of us business owners to heed.
At its pinnacle, Ringling Brothers circus billed itself as "The Greatest Show on Earth". Well, the the Dow Jones Industrial Average stock market index ("DJIA"), which could be the dubbed "The Greatest Market Index on Earth", shares a common trait with the circus: It is a relic from a different era and its efficacy as a broad stock market index has come and gone.
When the DJIA eclipsed the 20,000 milestone for the first time in January, it was lauded by the financial press as a major financial event. I'm not so sure.
Like the Ringling Brothers circus, the first stock market index was also created in 1880s. Charles Dow, editor of the Wall Street Journal, working in tandem with his associate Edward Jones, created the DJIA in February 1885. They tracked the DJIA for a decade and first published it as a twelve stock price-weighted market index on May 26, 1896 at a base number of 40.94.
The index grew to twenty stocks in 1916 and to its current size of thirty stocks in 1928, the same year the price divisor was added to the index calculation to account for stock splits.
General Electric is the only original stock remaining in the DJIA, but, technically this is it second stint in the index – it was removed and then re-added in 1907. Drop that trivia question at your next cocktail party.
The DJIA is managed by a committee and individual stock changes are subjective made on "as needed" basis. The objective is to maintain an index of large, respected US companies representing all twelve major economic sectors, excluding transportation, utilities and real estate. As of January 2017, the top three sectors were financial stocks at 21%, followed by industrials at 20% and then consumer services at 15%.
Since 1896, there have been fifty-one changes in the DJIA, the last one occurred in 2015 when Apple replaced AT&T.
The DJIA has become the most widely recognized proxy for the US stock market. And that's a problem when used as an investment performance benchmark because it is fraught with limitations.
First, the thirty stocks are no longer "industrial" companies and do not represent the full breadth of the US economy, nor does it fully emulate the broad US stock market by any measure, including industry, sector or company size.
More importantly, the DJIA's key fault is that it is a price weighted index, which means its value is calculated as the sum of the component prices of the thirty stocks in the index. So higher-priced stocks carry an outsized impact on the DJIA valuation. To be fair, this was the only viable type of market index for Dow and Jones to compute back in the nineteenth century, but is woefully outdated in this day and age.
This is not a frivolous point if you analyze the recent "Trump Bump "stock market rally that has vaulted the DJIA valuation since the election.
Goldman Sachs is currently the highest priced stock in the DJIA and was so on November 8th as well. Per Wall Street Journal, after the election through December 21, 2016, Goldman Sachs accounted for a whopping 24% of the total1 1,600-point jump in the DJIA as the stock rose furiously on the expectation of less financial regulation and higher interest rates under a Trump presidency.
The Standard & Poors 500 Index ("S&P500") is the other popular broad market index and it is definitely a better index with which to benchmark investment managers, but it is imperfect as well. Like most modern indices, the S&P500 uses a market value ("cap") methodology. It ranks the largest 500 US based public stocks based on market value size and then reconstitutes the stocks in the index annually.
Larger cap companies have a bigger weighting in the S&P500 index, which creates market return distortions, both positive and negative.
A textbook example occurred in 2015. The total return of the S&P500 in 2015 was only 1.2%. Digger a little deeper, the "FANG" stocks - Facebook, Amazon, NetFlix and Google, all four mega-cap stocks in the index – rocketed to a composite gain of 70% in 2015 and collectively adding 5% of total return to the S&P500 in 2015! In other words, stripping out these four stocks the other 496 stocks in the index posted a composite 4% loss in 2015.
As a benchmarking tool, the best market index is an equal-weighted model based on market valuation; all holdings are valued the same. There's no space in the financial press for a third market index approach, however, so just take the media's obsession with these two indices with a grain a salt when benchmarking your own investments.
Until next time, be well….Tim