As Tesla Inc.’s plodding path to the S&P 500 demonstrates, the people who oversee of passive benchmarks often do so with a dose of what seems like active management. But for all the flak index firms get for how they handle the process, past episodes show their instincts have their merits.
Just a few months ago, when Covid-19 first raged, strict scrutiny of S&P inclusion rules might have suggested dozens of companies were on the verge of being kicked out of the equity gauge, particularly in virus-ravaged industries such as energy and retail. Acting then would’ve spurred one of the biggest reshufflings the index had ever seen.
Fast-forward to now, and no such housecleaning has occurred. Instead, loath to create disruption, the keepers of the benchmark exhibited patience, waiting to see how the market evolved. Today, that tolerance is looking prescient. After the S&P 500 surged 25% since mid-May, the total number of companies whose businesses or market fundamentals put them at serious risk of ejection has fallen by half, to around 15, says Nicholas Colas, co-founder of DataTrek Research.
What’s more, the companies most at risk of ejection have been the stars of the recovery. They’re up 87% over the span, nearly 30 percentage points more than the S&P 500 itself.
“The rally in, well, everything since May has really taken the pressure off the S&P committee to revisit the index,” said Colas.
The mass resurrection is testament to the pace of change in 2020, a year in which almost any impulse to panic has been punished. The quickest plunge into a stock bear-market was followed by an equally breathtaking rally. In the last week, signs of a resurgent pandemic were countered with positive vaccine news. The biggest beneficiaries have been companies that bore the brunt of February and March’s selloff.
While the committee never stated publicly any plans for forbearance, the philosophy can be imputed from the data. At one point five months ago, some 100 companies in the S&P 500 were trading below one rough standard of sturdiness, the minimum market-value for inclusion -- $8.2 billion -- and only a handful got booted. Reluctance to hit the eject button shows the overseers’ resistance to rash actions, an ethos that may have informed the year’s other big inclusion drama: Tesla.
The electric-car maker met the last of the index’s qualifications in July, after it posted four profitable quarters in a row. But some noted that Tesla’s profits relied on the sale of regulatory credits to other carmakers that need help complying with toughening emissions standards. Whether its addition bodes well for the S&P 500 is a point of debate. A working paper posted by the National Bureau of Economic Research in July found that stock pops linked to the announcement of index inclusion have gone away, and the lasting effect on price in recent years has been downward.
On the other hand, companies at risk of ejection have been prime beneficiaries of the recent broadening in the stock-market rally. While tech megacaps are still rising, other industries are catching up. Since the March 23 bottom, an equal-weight version of the S&P 500 that treats Apple Inc. the same as Delta Air Lines Inc. has surged 70% to an all-time high.
Value stocks, a category that also encompasses many of the index’s problem children, have surged. An S&P 500 subindex of those companies last week beat its growth counterpart by the most since 2008. During the same period, energy stocks surged by a record 16%.
Even with that rebound, DataTrek’s Colas estimates that the largest chunk of the benchmark at risk of deletion comes from the energy sector, including companies like TechnipFMC Plc, Apache Corp. and National Oilwell Varco Inc. A few real-estate shares and retail companies such as Gap Inc. and Hanesbrands Inc. could also be at risk, he says.
But given that energy stocks make up just 2.3% of the S&P 500 -- the least of any sector and just about the lowest representation in the index on record -- the keepers of the passive benchmark may have another involved call to make.
“I would guess the committee would likely not delete any names there,” said Colas. “Better to wait and see how the commodity recovery plays out.”
Along with the $8.2 billion threshold, S&P inclusion rules say liquidity measures must be sufficient, and the sum of total earnings over the past four quarters has to be positive. But there’s leeway. In most cases, the index’s regulations treat those levels as prerequisites for inclusion -- not grounds for ejection.
“The addition criteria are for addition to an index, not for continued membership,” says the 41-page S&P U.S. Indices Methodology rule book. “As a result, an index constituent that appears to violate criteria for addition to that index is not deleted unless ongoing conditions warrant an index change.”
Human judgment is also part of the process. The committee aims to minimize turnover and also takes sector representation into account. Shifts in index composition are made as needed and “changes in response to corporate actions and market developments can be made at any time,” according to S&P Dow Jones Indices.
Eleven months into 2020, 15 companies have been booted from the S&P 500, including firms that have been acquired. That’s less than the number of companies that were replaced in each of the last two years, S&P Dow Jones Indices data compiled by Bloomberg show.
Of those that were dumped this year for reasons other than mergers and acquisitions, six were consumer discretionary stocks, including retailers such as Macy’s Inc., Nordstrom Inc. and Kohl’s Corp. Two were energy companies, one was a consumer staples firm, and another was a tech stock.
Most recently in October, industrial tech firm Vontier Corp. replaced Noble Energy Inc., which was acquired by Chevron Corp. E*Trade Financial Corp., which was purchased by Morgan Stanley, was replaced by Pool Corp., a distributor of swimming pool supplies. In September, the committee passed up an opportunity to add Tesla -- sending its shares tumbling -- and instead opted for online retailer Etsy Inc., chip-gear maker Teradyne Inc. and medical-technology firm Catalent Inc.
Christopher Grisanti, chief equity strategist at MAI Capital Management, doesn’t envy the index’s overseers, the “high priests of the S&P,” as he calls them.
“There’s certain market dislocations that would temporarily affect the qualifications of certain companies,” said Grisanti. “To kick them out because of temporary dislocations is probably not a wise thing. Having said that, I have sympathy for both sides of that argument, and I would not like to be a guy who has to do that.”
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