Etsy has been removed from the S&P 500. What’s next for this bearish stock now that it’s removed?

In September 2020, e-commerce company Etsy (ETSY 7.56%) was included in S&P 500 — an index of approximately 500 of the largest and most profitable US companies. Indeed, 2020 was a great year for the company, with revenue more than doubling from 2019. The booming business earned about $350 million in net income this year, which is why it was considered a good candidate for the S&P 500.

According to a recent study by McKinsey, a company remains in the S&P 500 for about 16 years after initially gaining inclusion. But Etsy didn’t even come close to that number. S&P Global announced that Etsy will be delisted on September 23 — just four years after joining.

Shares of Etsy are down more than 80% from their 2021 all-time high. And if that’s not daunting enough, shareholders now have to deal with its short-lived tenure in the S&P 500. But this news is surprisingly predictive better days around. the corner. Here’s why.

Why is Etsy getting kicked out of the S&P 500?

A company’s size and profitability are two of the biggest factors for inclusion in the S&P 500. When it comes to Etsy, it’s still a profitable business. It earned $116 million in net income in the first half of 2024. This was down 15% from the first half of 2023. But this craft market business is still profitable, though.

Many companies are excluded from the S&P 500 for troubling reasons. Sometimes they run into material struggles. Businesses can become unprofitable, put up for sale, and sometimes even go out of business. None of this happened with Etsy.

The main reason Etsy’s stock is leaving the S&P 500 is its market cap — the value of the company. When it was initially listed, the market cap was around $15 billion, and it would eventually exceed $30 billion. But now Etsy’s market cap has dropped to about $6 billion, as the chart below shows.

ETSY Market Cap data by YCharts.

According to Finviz, this makes Etsy the second-least performing stock in the S&P 500 right now, just ahead of Bath & Body Works. It is too small to warrant continued inclusion. Therefore, S&P Global is moving Etsy’s stock to S&P SmallCap 600.

If Etsy had been pulled from the S&P 500 for more serious reasons, that would be a different discussion. But the reality is that it’s simply too small to be there. That’s why I find it an interesting situation.

Why Better Days Could Be Ahead for Etsy Stock

According to recent research by Rob Arnott of Research Affiliates, stocks that are removed from the S&P 500 actually outperform the index on average for the next five years. This is partly because investors tend to be too pessimistic about a company the moment it is taken out. And when investors are too pessimistic, stocks tend to be undervalued.

Indeed, there’s a good chance that Etsy stock is undervalued today. Actions can be evaluated from different metrics. But the stock is trading below its five-year average from a sales, earnings and free cash flow perspective.

ETSY PS Ratio data by YCharts.

To reiterate, this would be completely different if Etsy had fallen on hard times. If they lost market share to a competitor, lost money, or faced litigation, it wouldn’t really matter if the stock was cheap or not. These things would be bad for business.

In contrast, Etsy’s core values ​​are actually modestly encouraging. In the company’s second quarter, its base of active sellers and active buyers continued to grow. Spending per active shopper decreased slightly. But that’s far less disruptive than if shoppers left the platform altogether. Moreover, it further increased its Q2 revenue by 3% due to increased revenue from the services it provides to sellers.

Etsy’s Q2 net income was down year-over-year, which some might consider problematic. But this is just a tax synchronization issue. Measuring profitability from a different perspective, the company’s operating income of $159 million in the first half of 2024 was up significantly from operating income of $87 million in the first half of 2023.

The business is stable and profitable. But its valuation has fallen sharply in recent years as investors are increasingly bullish on its long-term prospects. Instead, I think the business is fine and will return to growth, and as a result, the stock is undervalued today. That bodes well for outperforming the S&P 500 over the next five years, just like the S&P 500’s rejection in the past.