Why Do Stocks That Have Been Dropped By Index Funds Outperform The Newer Stocks Added.

According to research from the great 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 the subsequent three-years.  This finding seems counterintuitive. If a stock gets added to the S&P 500,the FTSE 100 or any other major index for that matter 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. So what’s the reasoning?

To understand the mechanics of Dr Siegel’s finding, contemplate the automatic nature of the S&P 500 selection process. At the beginning of 2017, the United States stock market consisted of $24 trillion in total wealth. About $8 trillion or 33% of that has been invested in passive investments  also knowns as index funds that track indices like the S&P 500.

As written previously, when investing via index funds 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.

As the index fund is forced to buy stocks that are about to enter the S&P500, you will see traders bid up the price and front-run on the stock to get profit. 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. This is bound to happen with cyclical stocks. For example we saw a number of resource stocks enter the main indices of the London and Toronto exchanges during the recent  commodities boom.

But really, the eye-popping difference of why dropped stocks outperform newer stocks is due to valuation. Each stock removed from the index is trading at 0.46x of the valuation of each stock entering the index. This is a huge 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 major index trackers would be a good place to start.

I have personally taken advantage of this valuation quirk. Last year, I bought shares in G4S soon after it was announced that it would be dropping from the FTSE 100. The forced selling of the stock by the index fund providers led to the share dropping to the point where it was trading at 12x earnings. At the time of my purchase, the companies fundamentals were completely divorced from its valuation. The share price of £1.88 was a far cry away from what I calculated to be the fair value per share; £3.35.

But look what has happened since. The company has rallied from the lows of last year to reach a share price £3.34 today. And if truth be told, nothing fundamental has really changed in the business. The reason why the stock has rallied hard is due to it being oversold and trading at a very low valuation. I am currently sitting on a 75%+ profit and that is without accounting for the dividend the company has paid me over the past year. When it comes to investing, the price you pay is everything. Always do your research on why a stock looks overbought or oversold as there is always more that meets the eye.