People are looking for good investments after this year’s bear market losses. Getting your stock portfolio right is especially important if a recovery is around the corner. If you’re deciding between all of the Dow Jones stocks and one of its popular constituents, Home Depot (HD 1.28%), then consider the following pros and cons for each.

Home Depot

Home Depot leads the home-improvement retail industry, capturing more than 15% of a fragmented market. Its sales were 60% higher than its closest rival Lowe’s last quarter. Home Depot also has significant traction with contractors and building professionals, and the company expects them to provide roughly half of its revenue within a few years.

Consumer sentiment and homebuilding activity are the most important catalysts for Home Depot. In the short term, there are some complications on both of those drivers.

Consumers have held up relatively well with the impacts of inflation, but there’s still concern. The Fed rate hikes combat inflation by pulling back on employment and economic activity. That will probably create an uphill struggle for Home Depot, which thrives on discretionary spending on big-ticket items and spending on home-improvement projects.

Person holding arms out on either side of their body, gesturing that they are chosing between two different options.

Image source: Getty Images.

Homebuilding is another issue. Mortgage rates are at their highest in nearly 15 years and demand is plummeting. Housing starts dropped 8% in September, while existing home sales fell almost 25%. This represents a major drag on demand for Home Depot, and these aren’t conditions that tend to change overnight. It will probably be at least a year until conditions are favorable again.

While it’s hard to see a catalyst for Home Depot stock in the near future, the stock is still an interesting long-term play at the intersection of retail and homebuilding. Builders haven’t kept up with new demand for homes, leading to a 4 million home deficit in available housing. That should solidify long-term demand for home-improvement retailers, especially as aging millennials become more affluent and wealth is transferred from the baby boomer generation.

In the meantime, Home Depot provides a respectable 2.5% dividend yield, and the stock’s 13.2 enterprise-value-to-EBITDA (earnings before interest, taxes, depreciation, and amortization) ratio suggests that some of the valuation risk has been removed from the stock. There’s clearly an opportunity for long-term returns, and it’s an interesting play for investors who are willing to buy and hold for at least five years.

Breaking down the Dow

The Dow Jones is a bit odd, as far as major stock indexes go. Where most indexes weight their constituents equally or based on market cap, the Dow throws a curveball by weighting the index according to share price. Its management team selects 30 prominent large-cap stocks from a handful of sectors. There aren’t strict rules on when it’s rebalanced or how it’s structured, giving lots of flexibility to the Dow team.

When Apple split its stock in 2020, it drastically changed the price-weighted Dow’s  exposure to that company and the tech sector. The Dow added salesforce.com that year to help bridge the gap, but investors can see how the Dow Jones’ methodology isn’t strictly scientific. That makes long-term performance somewhat unpredictable

Owning all of the Dow stocks provides a good amount of diversification but won’t necessarily mimic overall market performance. There are a relatively small number of holdings, compared to other major market indexes like the S&P 500 or the Nasdaq. There’s also some noteworthy industry concentration.

Home Depot makes up just over 6% of the Dow Jones at the moment, and the two certainly show some correlation. However, they’re likely to perform quite differently over the long term, given the exposure to tech stocks in the index.

The better buy ultimately comes down to suitability. Income investors looking for a stock to add to a diversified portfolio will probably prefer the characteristics that Home Depot brings to the table. Investors who need extra diversification would benefit from buying all of the Dow Jones stocks or a Dow-tracking exchange-traded fund (ETF) like the SPDR Dow Jones Industrial Average ETF Trust.

In both cases, these are best suited as an addition to a more extensive portfolio. They both deliver a mixture of stability, modest growth, and dividend income, which can be welcome features for any investor.

Neither of these are optimized for explosive growth, since Home Depot is a mature dividend stock and the Dow is diluted by value stocks. Growth investors should look elsewhere for big returns because both options are generally better suited for value investors.

Index investors should avoid going all-in in either case. Even though the Dow Jones is a popular index, it only has 30 holdings. It’s allocation doesn’t necessarily track the total market performance, so it needs to be supplemented with other stocks or ETFs.

Ryan Downie has positions in Salesforce, Inc. The Motley Fool has positions in and recommends Apple, Home Depot, and Salesforce, Inc. The Motley Fool recommends Lowe’s and recommends the following options: long March 2023 $120 calls on Apple and short March 2023 $130 calls on Apple. The Motley Fool has a disclosure policy.

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