Dump Citigroup and GM From the Dow

It's about time.

I told you last November that the editors at Dow Jones should dump both General Motors and Citigroup from the Dow Jones Industrial Average. I focused on GM in particular, given its history of posting losses even during years of record sales.

Now this: If the US government assumes greater control over US bank Citigroup or automaker General Motors, that might "trigger" their removal from the Dow index, according to the Dow Jones Index editor who oversees its components, the New York Post reports.

John Prestbo, editor and executive director of the DJ Indexes, which selects the 30 stocks in the Dow Jones industrial average, said he tracks both companies "every day to see what the status is," the paper says.

Should either stock be removed, "everything is on the table basically in terms of replacements," Prestbo said.

A recap of what I reported last November is below, with figures updated:

GM's History of Mismanagement

GM has been criticized for now switching gears fast enough as gas prices rose to sell what car buyers wanted, fuel-efficient cars, as GM dithered dumping its unjustifiable gas hogs such as the Hummer brand, the stock has plunged to levels around the price of a gallon of gasoline or a gallon of milk, levels not seen since the '50s.

GM's rapidly shriveling market capitalization at $1.2 bn is the tiniest in the Dow, with next in line Alcoa (AA). The aluminum manufacturer is valued at more than three times as much, $4.8 bn.

Ford has a bigger market value than GM, at $4.7 bn, but is not a Dow component. GM's status as a once iconic American brand is eroding as fast as that of Whirlpool, Eastman Kodak, Corning, and Sears.

The stock market doesn't need a gauge of the auto industry, as it's not a news flash that car makers are getting a $25 bn loan from US taxpayers to retool their plants to make more fuel-efficient cars, a move they should have made decades ago.

The Dow is a price-weighted average of 30 blue-chip stocks that are supposed to represent the largest and most widely held public companies in the country. The index of 30 has been the bellwether stock market index to watch since Oct. 1, 1928.

It's been a long time since the Dow has been thought to be singularly "industrial," a quaint anachronism as many of the Dow's 30 components have little to do with manufacturing or heavy industry. The editors at the Wall Street Journal get to decide which stocks make up the Dow.

It is time to dump GM from the Dow. (And dump Citi too).

Already, Kraft (KFT), whose former parent Altria Group (MO) was a Dow component until it was removed earlier this year, has replaced the disastrously managed American International Group (AIG) in September. Chevron (CVX) and Bank of America (BAC) replaced Altria Group and Honeywell (HON) earlier this year.

The predominant issue in choosing the right replacement for GM is the fact that the index is price-weighted, so any one stock can really swing the Dow. 

So that would rule out including the Federal Reserve, as Wall Street analyst Matthew Hougan suggests tongue in cheek, given that the Fed has been behaving more and more like a commercial bank, with massive lending to non-banks like General Electric (GE) and by buying up securities and debt instruments. General Electric is the only original member of the Dow--for now.

So which stock should replace GM? And Citi too?

Tech Stocks to Consider

There are four tech stocks in the Dow: Hewlett-Packard (HPQ), IBM (IBM), Intel (INTC) and Microsoft (MSFT).

Apple (AAPL) and Google (GOOG) have been talked about.  

However, given Google's size and heft-its market cap is $107.6 bn-its stock price might be too much in terms of yanking around the Dow, as again, the index is price-weighted (see below).

Apple, too, given that the volume of its shares traded tend to be thin, so earnings and other market news can whipsaw the stock and add to volatility. Perhaps to be considered, too, is the fact that its brand is closely identified with founder Steve Jobs, now said to be battling a rare form of pancreatic cancer.

Telecom and communications equipment giant Cisco Systems (CSCO) would be a strong tech contender. It's got a $102.6 bn market cap, strong sales, and fairly conservative management given its history of earnings forecasts. Oracle (ORCL) with a market cap of $91.9 bn could also be considered.

A Food Retailer to Consider

What about PepsiCo (PEP), joining Dow members Coca-Cola (KO) and McDonald's (MCD) as a food retailer? With a market cap of $88.5 bn, the owner of Frito Lay and Gatorade as well as the soda Pepsi has been delivering steady sales growth.

Other Ideas

Hougan has suggested Philip Morris (PM), with a $90.3 bn market cap, ConocoPhillips (COP), with $79.7 bn, and Schlumberger (SLB) $60 bn. Also he says what ought to be taken into consideration is how various sectors are represented in the Dow versus the S&P 500.

 Choosing the Right Replacement is Key

The DJIA is price-weighted, meaning that a stock's weighting in the index is based on its price, regardless of how many shares outstanding the company has.

Despite its name, the Dow Jones Industrial Average, the index is not really a straightforward, actual average arrived at by adding up its stock prices and dividing by 30.

That's because of things like stock splits. Say a Dow company has just 100 shares of stock and its stock trades at $100.

However, the company's executives, who should always worry about their capital base, figure that there will be more investors plowing into their stock if the shares were trading at $50. So they do a stock split.

One hundred shares of stock at $100 would deliver a market cap of $10,000. A stock split would mean 200 shares of stock at $50-same market cap of $10,000-but now investors have more shares and company executives can breathe easier because their equity base is a bit more flexible.

However, the change in the stock price due to the split would bring down the value of DJIA, even though there is no fundamental change in the stock. 

So to take into account the effect of price changes from stock splits, the Journal editors calculate the DJIA by using a Dow divisor.

To arrive at the value of the index, the component prices are added up and then divided by a divisor, a number that changes whenever one of the Dow stocks has a dividend or a stock split.