If You're Looking for Value, the Dow's Not the Place to Be

Don't bother with the 30 stocks that make up the Dow Jones Industrial Average. After reviewing the financials of each of the Dow stocks a few weeks ago, I'm convinced it's the last place that investors who are trolling for bargains will find compelling value.

This doesn't mean the Dow average will be going down anytime soon, just that it will have difficulty making upside progress with so many stretched valuations. Investors focused on Dow stocks are already missing some hearty action in the average stock, which has been in a distinct uptrend since December, while the Dow is down.

It's a Story of Excess

The purpose of a "correction" is to correct excess. And Wall Street played the big-caps, notably the Dow, to excess in the most recent cycle, which lasted from 1995-2000. Expect a reversion to the mean that could last a few years, as the excess of that cycle gets unwound and corrected.

Just look at my Top-10 column for examples of outperformance of smaller companies in the current, new cycle. Three of my Top 10 are retailers: J.C. Penney(JCP), Circuit City(CC) and Office Depot(ODP). The market value of each was less than $5 billion when I recommended them in December -- compare that with retail behemoth and Dow component Wal-Mart(WMT), which is worth about $230 billion.

So far this year the stock of Wal-Mart has barely budged (up less than 2%), while my three picks are up an average of 106%.

Peak Profitability

Another area of excess is the peak profitability that Dow companies enjoyed in the last cycle. If you go back a couple of decades, it's easy to see that the Dow companies reveled in an unusual period of margin expansion in the late '90s. Even if these margins can be maintained, they are not going to expand to the same degree they did in the last cycle.

Sticky Hands

Many money managers are holding fast to Dow stocks because they are not going down (much) and they are perceived as "safer" than many Nasdaq stocks. The liquidity of positions in big-caps is also attractive to money managers.

But at the end of the day, this game isn't about price action or perceptions of safety or liquidity -- it's about value. In fact, over the long haul, it's exclusively about value. Buying Dow companies that are two or three times as expensive as smaller companies, when compared using similar metrics, is a loser's game.

If encouraged or pushed to buy any of the expensive Dow stocks, smart investors would do well to quote Hugh Grant's character in the movie Mickey Blue Eyes: Fuhgetaboutit.

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