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Oh no, a stock you own is about to be removed from a major index. It no longer measures up, perhaps because of dismal performance over the past several years.
Time to call it quits and sell, right?
Maybe not. Research, and recent anecdotal evidence from several enticing rebounds, suggest that stocks can outperform after their removal from an index like the S&P 500.
That raises the possibility that dumped stocks should be considered potential buying opportunities, and it reinforces the strategy of buying stocks that have fallen out of favour with investors.
Good news: You have the opportunity to investigate this wild-looking thesis in real time.
On Friday, the folks who manage the S&P 500 announced a couple of changes to the venerable blue-chip index as part of a quarterly rebalancing.
Marvell Technology Inc., a semiconductor company, and Flex Ltd., an electronics manufacturer, will be joining the index.
That means two stocks will leave; Pool Corp., a swimming pool supplies distributor, and Campbell’s Co., the soup and snack maker.
To be clear, you would have done a lot better over the past 12 months owning shares in Marvell and Flex, rather than Pool Corp. and Campbell’s. The two tech stocks have gained 255 per cent, on average, during this one-year period; the pools-and-soup stocks declined by 36 per cent.
In theory, index tweaks would appear to add fuel to this sort of divergence.
That’s because an important index like the S&P 500 is the bedrock for any number of index funds that mirror its performance. These funds must buy the new additions, and the buying pressure should push share prices upward, for a little while at least.
Similarly, stocks that are dumped should suffer from near-term selling pressure, as funds sell shares that are no longer relevant to a benchmark.
But the fireworks don’t last long, because the market is very efficient at working out these changes. And that’s why contrarian investing instincts – eschewing the popular names and approaching the stocks no one wants – can work magic.
Enphase Energy Inc. was removed from the S&P 500 last year. This year, the stock has rallied 60 per cent. Caesars Entertainment Inc., also removed last year, has gained 25 per cent this year.
Lumen Technologies Inc. and Zions Bancorp N.A. are two other recent examples of stocks that were removed from the S&P 500, and performed just fine afterward.
It is not a hard-and-fast rule, but some pros have noticed that there is a pattern here.
Rob Arnott, the founder and chair of Research Affiliates, argued in a 2024 research paper that there is a wide valuation gap between frothy stocks that are added to major indexes and cheap stocks that are deleted.
Additions are priced at about twice the market multiple, based on price-to-earnings, price-to-book, price-to-sales and other popular valuation ratios. Deletions are priced at about half the market multiple.
“This enormous four-fold spread implies an equally enormous gap in the companies’ expected future prospects,” Mr. Arnott said in his paper.
According to his calculations – using market data from 1990 through 2022 – additions underperformed the S&P 500 by 1 to 2 per cent the year after they joined the benchmark. However, deletions outperformed by an average of more than 5 per cent, each year, over the next five years.
Things may be looking up for Pool Corp. and Campbell’s Co. and many of the other unpopular, undervalued stocks that have been jettisoned from major indexes.
Do you prefer buying unpopular stocks, and has that approach worked for you? Send your biggest stinkers to dberman@globeandmail.com.
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