“The Dow Jones Industrial Average undergoes its second major facelift in more than four years today, and the change is leaving some investors and analysts with a knotty problem,” writes E.S. Browning in today’s Wall Street Journal.

“Beginning with today’s trading, three new stocks — insurance giant American International Group, drug maker Pfizer and telephone-service provider Verizon Communications — join the 30-stock Dow industrials. They replace long-distance telephone company AT&T, photography concern Eastman Kodak and paper maker International Paper. The coming changes were announced last week.”

“The problem: Which stocks to own for the future — the bright new arrivals or the tired old stocks that are departing?”

“Betting on the new stocks would have been the wrong way to go the last time the Dow was revised, in November 1999. The four stocks that joined the blue-chip average held up for only about four months after they entered. Then, they flopped and, as a group, were eventually overtaken by the stocks they had replaced, according to calculations by Dow Jones Indexes, an operating group within Dow Jones & Co., publisher of The Wall Street Journal. The group calculates and licenses the industrial average, and Journal editors pick the stocks.”

“Some contrarian investors think such price movements could happen again.”

” ‘When stocks are removed it can be the low point and that can set them up to rebound,’ says Charles Carlson, a money manager and writer in Hammond, Ind. He publishes a newsletter called Dow Theory Forecasts and this year brought out a book called ‘Winning With the Dow’s Losers,’ arguing that the worst-performing Dow stocks each year are likely to do the best in following years.”

” ‘My sense is that you probably are going to see Eastman Kodak and AT&T do pretty well this year after they get past this little quagmire,’ Mr. Carlson says. It is certainly true that the four stocks brought into the Dow industrials in 1999, HomeDepot, Intel, Microsoft and SBC Communications, all have fallen sharply — anywhere from 25% to 50% — since then. And it isn’t the onetime highfliers Intel and Microsoft that have done the worst. Telephone-service provider SBC, which has suffered from the intense competition and overinvestment in the telecommunications business, has fallen the most in price.”

“The four stocks that were dropped from the index in 1999 have done better. Two have posted actual price gains since they left the industrial average: Sears Roebuck, which has risen about 50%, and Dow Chemical, which is up a few percentage points. Dow Chemical wasn’t in the Dow industrials itself but acquired former Dow component Union Carbide.”

“Two of the former Dow members are down: ChevronTexaco (successor to former Dow component Chevron), which has fallen only slightly, and Goodyear Tire & Rubber, which has tumbled nearly 80% in price.”

“Some analysts view the weakness of the stocks that joined the Dow in 1999 as an aberration, a product of the overheated market of that era. An analysis of stocks that entered and left the Dow in years before 1999 indicates that the new stocks generally have done better than those they replaced, says stock-trading strategist Ryan Renicker at brokerage firm Credit Suisse First Boston in New York. ‘When companies are added to indexes, such as the Dow, they are considered to be firms that are market leaders within their respective sectors,’ Mr. Renicker says. ‘This is likely one of the key factors that drives these stocks’ subsequent outperformance following their addition.’ “