According to the research of Wharton finance professor Dr. Jeremy Siegel, 82% of stocks that are removed from the S&P 500 go on to outperform the stock that replaced them in the index during his examination of subsequent three-year performance of the stocks.
This finding seems counterintuitive. If a stock gets added to the S&P 500, it must be riding a momentum wave that has seen its valuation increase. Likewise, a stock that is removed from the S&P 500 must have been riding a wave of sluggish performance that warranted its exclusion from the index. What gives?
To understand the mechanics of Siegel’s finding, contemplate the automatic nature of the S&P 500 selection process. At the close of 2016, the United States stock market consisted of $24 trillion in total wealth. About $8 trillion of that has been invested in passive investments that track indices like the S&P 500.
This means that investments get made irrespective of fundamentals. So when a stock gets included in the S&P 500, you have that machine of S&P 500 indexed investments that automatically purchase Stock X as soon as it gets included. It is not a coincidence that the average stock added to the S&P 500 trades at a P/E ratio of 32 when it is entered into the index.
When a stock is removed from the S&P 500 index, the same mechanics occur in reverse. That $8 trillion machine that included Stock Y must sell it in order to comply with the fact that its investments must mirror the S&P 500. At the time of exclusion, the typical stock removed from the S&P 500 has a P/E ratio of 15.
It is also possible that the stock entering the S&P 500 index is near the peak point of its business cycle while the stock removed from the S&P 500 is near the bottom portion of its business cycle. But really, the eye-popping difference is about valuation. Each stock removed from the index is trading at 0.46x of the valuation of each stock entering the index. This is a significant gap. The subsequent three years after the index reshuffling tend to incorporate the new stocks seeing their valuation drift from 32x earnings down to 20x earnings while the delisted stock recalibrates its valuation from 15x earnings up to 20x earnings. If you are putting together a research list of value investments to consider, the corporations recently removed from the S&P 500 would be a good place to start.
Originally posted 2017-01-07 20:59:34.