How to Ride the Dow as a Stock Picker

Color them true-blue, the bluest of the blue chips, among the best known corporate enterprises in the world.

They are the 30 stocks that make up the Dow Jones industrial average, the world's best-known stock market index.

The 100-year-old index is also a good place to start looking if you're interested in buying shares of individual companies, some experts say.

David and Tom Gardner, famous for their Motley Fool investment site on the Internet (www.fool.com), argue that a new investor's first stocks should include Dow stocks. They devote an entire section of their best-selling investment guide to this argument.

Of course, by just buying into the Dow, you could miss out on many opportunities, including high-tech revolutions, says James Fraser, who heads Fraser Management Associates in Burlington, Vt. And many giants like Microsoft and Intel aren't in the Dow.

But the index steers you to a list of companies that represent the cream of American industry.

"These indexes are 'managed' indexes," not random samples, explains Abby Joseph Cohen, market strategist at Goldman, Sachs. She refers to the Dow and its larger cousin, the Standard & Poor's 500 index.

New kids on block

That became clear in March, when the editors of The Wall Street Journal, who oversee the Dow, booted out four companies, and replaced them with four others.

Gone are Bethlehem Steel, Texaco, Westinghouse, and Woolworth. The new kids are Hewlett-Packard, Johnson & Johnson, Travelers Group, and Wal-Mart.

Analysts say these firms push the Dow's weighting away from old-line industries (oil and steel) and toward the service, financial, health, and technology sectors that are fueling much of the nation's economic growth.

Dow stocks "can have a bad year. But usually, they have better years than almost all other companies in the United States," says another investment firm officer.

One reason, says Mr. Fraser, is that these companies are global in scope, not dependent just on America for growth.

Buying a Dow stock "can be a particularly useful way of teaching children about the market," Mr. Fraser says, since they immediately recognize Walt Disney, IBM, or General Motors.

Overpriced?

But be warned: Some Dow companies have risen so much in the six-year bull market that some analysts say they're overvalued by as much as 20 percent.

Even bullish analysts see few of these companies as bargains right now.

As with any stock at any time, you should be selective in creating a Dow-based portfolio.

Stock pickers use two common investment strategies: "growth" and "value."

A growth strategy targets companies with rapid earnings growth on the horizon. A value strategy seeks stocks that are attractively priced relative to the earnings, sales, or assets of a company.

Fraser recommends buying Dow firms that are poised for future growth.

The "dogs of Dow" theory (see story below) uses a value approach based on price relative to dividends.

While popular with Dow followers, a dividend-based strategy has fallen out of favor with many investors in the broader market.

The Dow may change components from time to time, but most companies stay on the index for years. (General Electric is the only Dow company that goes back the full 100 years.)

Five times the Dow has fallen more than 20 percent. Still, as the Gardner brothers note, the Dow has mirrored the broader S&P 500 index since 1930, registering a compound annual growth of 10.5 percent.

Not all stock investors favor Dow companies.

"As a risk reduction measure" buying Dow stocks can be appealing, says John Markese, president of the American Association of Individual Investors in Chicago. "They are large, well-managed companies."

But just buying Dow stocks alone "sounds dangerous to me," he adds.

A person is better off investing in a diversified mutual fund, such as an index fund that will own the 500 S&P companies, Mr. Markese says.