Friday, 20 April 2012

Looking for Value Stocks amongst S&P 500 Deletions

The S&P 500 index is the bellwether of US stocks and it forms the basis of automatic purchase decisions for massive amounts of passive investment. Companies that get added to the S&P 500 experience a sudden price boost as all those funds holding the index create upwards purchasing pressure. But what about the companies that get deleted to make way for the new entrants since the index only contains 500 companies? Do they plummet as a result of selling pressure?

Revenge of the dumped - better returns!
Contrary to what one might expect, the deleted companies are not, on average, basket cases headed for bankruptcy and oblivion, though some are. In fact, though they do fall initially, the deletions over the 6-24 months following the index removal do much better than the additions to the S&P 500!

Huffman Funds' William Hester tells us in Misfit Stocks how the rejects from 1998 to 2004 consistently outperformed the additions each year and cumulatively up to March 2005. The stats do exclude companies like Worldcom and Enron whose bankruptcy was known at the time of deletion but they do include companies like Laidlaw, Polaroid and Bethlehem Steel that went into Chapter 11 later. The strong bounce-back of other companies overcame the pain of 100% losses on a few.

Whether its investors driving market cap too low or the S&P index maintenance committee deciding (see the Index Fact Sheet on the Standard and Poors S&P 500 webpage for how index additions and deletions work) that the company is no longer representative of the industry or the overall economy, Hester interprets the deletions as often reflecting a perception that the companies are old economy, or in a declining sector. As he notes: "Neglected and under-appreciated companies often have more life left in them most investors expect."

Life after being dumped
Perhaps it is a wake-up call to management who suffer the indignity of being excluded from the prestigious S&P 500 club that motivates improved performance for companies that are not terminally ill. Some evidence of this comes from the research paper Discretionary Deletions from the S&P 500 Index: Evidence on Forecasted and Realized Earnings by Stoyu Ivanov of San Jose State University, which found that "... actual earnings of firms discretionary removed from the S&P 500 index on average increase." Ivanov's data also covers more years - 1989 to 2007 - which enhances the idea that something consistent is going on. Nevertheless, the general caution still must be stated that the number of companies involved through the years is quite small; that sample size limits the certainty of this effect.

Maybe the better stock returns subsequent to deletion also reflects that it is easy afterwards for the company to beat much lowered investor expectations as Hester suggests.

Whatever the reason, after a stock decline before and around the deletion date, stock price recovery begins (again, this is an average and certainly not true in the case of every company) soon after deletion.

Finding and tracking recent S&P 500 deletions
Wikipedia's List of S&P 500 companies includes a table of additions and deletions going back to 2009. It's a much better source than S&P's own page linked above, which contains the official index change announcements but no convenient summary. Interestingly, the Wikipedia summary shows that most of the index deletions come about from mergers that eliminate a company as a separate entity.

There have been six non-merger caused deletions since November 2011 - Janus Capital Group (NYSE: JNS), MEMC Electronic Materials Inc (NYSE: MFR), Monster Worldwide Inc (NYSE: MWW), Tellabs Inc (NASDAQ: TLAB), AK Steel Holding Corp (NYSE: AKS) and Compuware (NASDAQ: CPWR). The Google Finance price chart of the four months since deletion shows four stocks lagging the S&P 500 (black line in the chart), one about the same and one (JNS) well ahead.

A few of the companies deleted further back in December 2010 provide more colour to the picture of what can happen to deleted companies.
  • Eastman Kodak (now only listed a pinksheet under symbol EKDKQ),a classic old economy business struggling against technological change in photography, eventually filed for bankruptcy in January this year, though it still attempting to come out of Chapter 11 and continue as a viable business.
  • Office Depot (NYSE: ODP) is still about 36% below its price at deletion but has risen considerably above lows at the end of 2011. The latest Q4-2011 results in February 2012 showed a company with stabilized sales and slightly revived earnings that is continuing to restructure.
  • New York Times (NYSE: NYT), another old economy company, has stable or slightly declining revenues but has increased profitability recently in its latest quarterly results. In the Motley Fool stock discussion boards, investor sentiment is still said to be negative.

All three lag the overall S&P 500 by a considerable degree since deletion and investors have suffered large declines in stock price as the Google Finance chart below shows.

Investor takeaways
1) At the very least an investor in these companies will have to be patient and brave since the possibility of large losses exists.
2) Success is not guaranteed - some do well, others continue to tank. Serious analysis of the companies would be needed to determine likelihood of regained growth, recovery or even survival. (For those who may wonder, there is (as yet!?) no "Index Outcasts" ETF to provide diversification by holding all deleted companies.) Despite these limitations, index deletions can still be a useful tool for the value investor to look for potential investing candidates.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

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