1 Former S&P 500 stock down 82%, which history suggests buying at a once-in-a-decade valuation

Usually, deleting a company from S&P 500 the index makes it feel like an action to avoid. However, a study from Research Affiliates looked at stocks deleted from the S&P 500, Nasdaq-100and Russell 2000 indexes and showed that the exact opposite can be the case.

Running a backtest from 1991 to 2018, Research Affiliates found that stocks removed from the major indexes continued to outperform the broader market by five percentage points annually over the next five years.

As counterintuitive as it sounds, it makes some sense. Typically, following the announcement that a stock is leaving an index, it is sold off — often into “value” territory. Because of this lower share price and subsequently lower valuation, these stocks appear to outperform, in part because they have a lower bar to clear to produce market returns.

A company recently delisted from the S&P 500 that looks poised to deliver that comeback over the next five years (and beyond) is a creatively focused e-commerce powerhouse. Etsy (NASDAQ: ETSY). Besides the history that suggests Etsy could be poised to outperform, here’s what else makes the company an attractive investment as it trades at a once-in-a-decade valuation.

Etsy’s Wild Ride

Based on its two-way network of 9 million sellers and 96 million active buyers, Etsy’s core mission is to “keep commerce human.” Empowering small business sellers — 97 percent of whom operate from their homes — Etsy’s unique, often personalized, and handmade goods stand in stark contrast to the commodity goods offered by Amazon or Walmart.

Thanks in part to this counterpositioning moat and the company’s unique product offering, Etsy has grown sales and free cash flow (FCF) by 36% and 42% annually since 2017. However, the road to generating these impressive growth rates in that period was anything but smooth.

Having experienced staggering growth during the pandemic thanks to sales of homemade masks and the need to shop from home, the company has struggled to shift gears back to higher sales growth rates. Because of this slowdown, Etsy’s market cap has fallen from more than $30 billion to its current mark of about $6 billion, prompting the S&P 500 to drop it from its index.

Ultimately, there’s no denying that Etsy is a much stronger business than it was in 2017. FCF alone is 11 times higher now than it was seven years ago — it just wasn’t sense like a great ride. Even so, the company remains home to two promising indicators that point to superior performance and has a specific growth area that could restart the company’s upward trajectory.

The story continues

Etsy Indicators for Superior Performance

First is Etsy’s impressive cash return on invested capital (ROIC) of 40%, which would rank strongly among S&P 500 stocks. A high and growing ROIC on cash like Etsy’s, comparing the company’s cash generation with debt and equity, it is often an indicator of future performance.

Thanks to this high ROIC on cash and solid FCF margin of 25%, the company quickly began buying back shares at much lower prices, reducing its share count by 9% in just the last three years. Historically, stocks like Etsy, with strong FCF generation and large share buybacks, have outperformed the overall market by 5.5 percentage points annually between 2000 and 2019, according to a study from S&P Global.

A final reason to believe Etsy’s turnaround story is management’s focus on improving its mobile app. Currently, only 45% of the company’s buyers have the Etsy mobile app. Compare this to the fact that the vast majority of millennial digital shoppers already have the Amazon app downloaded, and it’s clear to see that this is an area where Etsy needs to grow.

If Etsy can prove successful in converting its buyers to its mobile app, it could be a massive development for the company, as mobile app buyers generate 75% more purchase days, meaning they shop for almost two times more often.

A once-in-a-decade assessment

With shares down 82% from all-time highs, Etsy’s FCF yield of 9.6% (the inverse of the price-to-FCF ratio, so higher is cheaper) remains at its highest level in a decade.

Even after accounting for stock-based compensation, Etsy trades at just 15 times FCF, making it about half as expensive as the S&P 500 average.

If Etsy delivers even minor improvements in the penetration rate of its mobile app or finds mild success with its search experience and international operations, it could quickly surpass this low valuation. And if, unfortunately, it stays cheap for a while, the company’s buybacks will become all the more valuable.

Ultimately, Etsy’s growth story has been a wild one. But it has matured into a cash-generating behemoth that investors shouldn’t ignore now that it’s not in the S&P 500. In fact, history suggests buying.

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John Mackey, former CEO of Whole Foods Market, an Amazon subsidiary, is a board member of The Motley Fool. Josh Kohn-Lindquist has positions in Etsy. The Motley Fool has positions in and recommends Amazon, Etsy, and Walmart. The Motley Fool has a disclosure policy.

1 Former S&P 500 Stock Down 82%, Which History Suggests Buys at a Once-in-a-Decade Valuation was originally published by The Motley Fool