Index rejections are finding favor with stock market bargain hunters

Unlock Editor’s Digest for free

FT editor Roula Khalaf selects her favorite stories in this weekly newsletter.

The passive investment industry has never been stronger than it is today. Index inclusion has consequently become a holy grail for companies to boost valuations and reduce capital costs. The prevailing theory is that index inclusion is great for those in the club and a disaster for those who aren’t.

It’s not always like that. There is evidence that companies that are dropped from the S&P 500 tend to outperform, according to Rob Arnott of Research Affiliates.

Indices are in a constant state of flux as underperformers leave and outperformers join. Companies about to enter indexes typically outperform the stocks they will soon replace by 100% or more before joining. Index inclusions should then build momentum, lifting ratings and continuing the good run.

But, Arnott notes, the performance of new additions versus deletions mostly occurs between when the impending change is announced and when it actually happens. Earnings are on average reversed one to two years after that. The opposite position to take would be to support those who are removed from the indices at the expense of those who join as long-term bets.

Index mechanics play a role in this. With more than 20% of S&P 500 assets tied to the index, wipeouts are under severe selling pressure as the shift unfolds. Add to that the poor performance that got him fired in the first place: the stage is set for a comeback.

Deletes tend to be deeply discounted: their average price/earnings ratio is at a 30% discount to the index average. Carpenters hyped-up average a relative valuation premium of 80 percent on the same basis.

Perhaps it’s no surprise, then, that since 1991 write-offs have outperformed the S&P 500 by an average of 28% five years after they were dropped. But beware: That relationship has fizzled out over the past decade thanks to the S&P 500’s amazing tech-driven performance and the relatively poor performance of low-value stocks.

Lex scanned the companies that were kicked out of the FTSE 100 in 2023 to see if this theory held true in the UK market. Discretionary index deletions (which exclude CRH because he left voluntarily) outperformed the index by 15% on average six months after exit. British Land and Hiscox (who recently joined) in particular. The same figure for those who joined simultaneously was just 7%.

Those that are dropped are worth a look for bargain hunters.

[email protected]