Chasing the Index Effect
December 16, 1999
By Ian Mount
RIDING THE INDEX WAVE
smartmoney.com
Data from 12/18/98 to 12/15/99
Source: DJ Interactive
FOR WANT OF A more poetic moniker, they call it the "Index Effect."
After the close of the trading day on Nov. 30, Internet portal-master Yahoo! (YHOO) announced that it would be added to the Standard & Poor's 500 index, the 40th company added this year. Between that moment and when it was added to the index ? after trading had closed on Dec. 7 ? the company mushroomed by $135.25 a share, or 63.6%, from $212.75 to $348.
A combination of factors lifts stocks when they're included in the S&P 500 (and, to a lesser extent, in other indexes). First, fund managers of the 96 S&P 500 index funds out there add the stock to their portfolios so that they mimic the index itself. This accounts for a tidy amount of stock purchasing. According to David Blitzer, the managing director and chief investment strategist at S&P, the keepers of the index, around 8% of a new addition's outstanding shares are absorbed by index funds, "who will probably sit on it and not trade it."
"It's sort of like an 8% share buyback," he says (for more on the effects of share buybacks, see our previous screen).
The rest is caused by day and active traders who are trying to "game" the index managers and the index effect, says Brad Pope, head of domestic indexing at Barclays Global Investors. And, Pope says, stocks are getting their index effect faster these days than before, which means that investors have to be nimble ? and a bit lucky.
"[The rise] happens now virtually immediately. Previously it would trend kind of into the addition date," Pope says. But it's a difficult game to play because, he says, index funds don't necessarily follow any single guideline for buying the new additions. "There's not a pat 'buy early' or 'buy late' or 'buy all on the day that it's added.'"
But for those who know how to play it, the index effect is a good thing.
While the usual index pop is much lower than the one Yahoo experienced ? according to Standard & Poor's, the average rise between announcement and inclusion has been 8.1% in 1999 ? it is indicative of a well-known phenomenon and one that investors and brokerages both follow. Investors who can guess what stock is next to be included in the S&P 500 can see quite a pop. So how are the lucky stocks chosen?
In today's screen, we followed Standard & Poor's guidelines, along with our own recipe, and we came up with 20 bachelors that could find themselves asked to the big dance. And while these guidelines combine the vague and obvious, they provide enough guidance to get one's hand around the subject.
Much of the S&P guidance falls into the "industry leader" category: companies should be among the largest in their industry and "relatively stable." The S&P committee that chooses these stocks is also on the lookout for action (of the market variety), searching for stocks that have high trading volumes, are involved in important and emerging industries, and are not closely held.
When he's not answering obvious questions about the S&P 500 index, S&P's Blitzer heads the nine-member committee that chooses additions and deletions. He says the committee meets about every month to examine its short list of 10 or so possible additions. Those additions come onto the index when a current member is merged out of existence or when a member simply stinks too bad to stay. The former is much more likely than the latter: Of the 40 companies that have been dropped this year, only eight still exist as independent entities, and several of those are nothing more than the husks left behind when an index member's most profitable parts have been carved out.
In the near future, a space is likely to open up if MCI WorldCom (WCOM) and Sprint (FON) get together, since they're both in the S&P 500 (as is Sprint's wireless tracking stock ? Sprint PCS (PCS)). Then there's the upcoming BP Amoco (BPA) acquisition of Atlantic Richfield (ARC), which will likely open up a space because Atlantic Richfield is a member; BP Amoco probably won't take its place because it isn't based in the U.S. and the S&P shies away from foreign-based companies. So, who will get these two places?
Well, E*Trade Group (EGRP) was a popular rumor candidate during the lead-up to the Yahoo announcement, and some proponents, perhaps stung by rejection, still boost it as the next addition. Eric Teal, vice president of investments in the institutional investing arm of First Union (FTU), says, "I thought E*Trade would be added before Yahoo," and adds that a stock in the finance, energy or telecom sectors will likely be next. As a possible replacement for Sprint, Teal mentions Qwest Communications International (QWST).
In a previous column, SmartMoney.com columnist and able raconteur Paul R. La Monica pointed to E*Trade and to two other companies that made our list ? Hog-builder Harley Davidson (HDI) and barista-behemoth Starbucks (SBUX). Though these two are less likely ? they certainly don't fill the finance, energy or telecom niches opened by the mergers mentioned above ? they are leaders in their respective fields (try NOT seeing a Starbucks coffee shop on any given day).
Since the S&P 500 is something of a big-company club, we also looked for large-cap candidates that haven't yet been let in the door. The only stock on our list that had a higher market capitalization than the average of S&P 500 companies ($23.1 billion) is Veritas Software (VRTS), with a $27.3 billion cap. This Mountain View, Calif.-based company sells "data-storage-management" software, which has seen quite a surge in the storage-hungry Internet world. The company's revenues have grown 224.3% year-over-year during its last quarter, and its earnings are projected to grow by about 48% annually over the next three to five years.
The next largest company on our list is Siebel Software (SEBL). This San Mateo, Calif., company makes customer-relationship-management, or CRM, software, which has also seen an insane rise in popularity due at least in part to the Web, which demands more advanced customer-service and marketing software to maximize sales. Much like Veritas, Siebel is expected to see its earnings expand by about 40.6% annually over the next few years.
And what does Standard & Poor's Blitzer say about the whole process? Well, for obvious reasons he won't part with the names on S&P's short list. The lobbying process is an intense one, with companies sending reams of information his way (but please, no confidential information, he says). Right now, it seems that another Internet pure play a la Yahoo is unlikely, at least from our reading between the lines of Blitzer's statements. "I'm sure we will [add another] over time," he says. "Do I have a little hit list? No."
Something else Blitzer says suggests another place to look for prospective additions to the 500 ? the other S&P indexes. "If it's a company that's already in one of our indexes, we already know it," he says. Teal seconds this view, pointing to the S&P Mid-Cap 400 index as the indexing equivalent of baseball's AAA minor leagues and noting that over half of the additions this year have come from that index. (By our count, 29 of the 40 additions to the S&P 500 came from the junior index.) All the companies on our screen are S&P 400 members.
For investors who miss getting in on the preaddition pop, the old aphorism "Better late than never" is downright wrong. In our analysis of stocks that have joined the S&P 500 index this year (download table here, or here if you don't have Excel), the average stock slid 0.7% on the first day of trading after its official addition and barely kept its head above water ? rising all of 0.1% ? over the first 10 trading days. And over the longer haul? From their addition through Tuesday's close, the 40 newcomers averaged a less-than-stunning gain of 1.6%. And Yahoo, that Golden Child of the S&P? It lost 8.2% on its first day as a member of the 500 club. |
