In the U.S., winners are rewarded with trophies and parades, while losers are left to reflect on what went wrong. In 2020, Apartment Investment and Management (AIV) was removed from the S&P 500 index to make way for Tesla, Inc. (TSLA). It was expected that AIV’s management would fade into obscurity while Tesla received extensive media coverage. However, in the six months after Tesla replaced it, AIV had an 80% better relative return. While AIV, like the rest of the real estate industry, later faced challenges as interest rates spiked in the early 2020s, its stock price is still up about 60% since then. And AIV isn’t alone. Companies removed from major indexes like the S&P 500 have historically outperformed the market by as much as 5% annually over the following five years.
Key Takeaways: Being in the S&P 500 means individual and institutional passive investors will automatically buy a company’s stock. It also enhances a company’s visibility and reputation. Being removed from the S&P 500 indicates the company is no longer considered one of the largest or most important publicly traded firms in the U.S. Yet, companies removed from the S&P 500 tend to outperform the market by up to 5% annually for five years after removal. What Happens When the S&P 500 Adds or Removes Stocks From the Index? Getting removed from an index is not associated with success. Inclusion in the index, especially in today’s passive investing-dominated market, is believed to boost a company’s share price almost automatically. It also increases the company’s visibility and credibility, demonstrating that the company is among the best and biggest in the country. However, there may be a silver lining to being dumped. Research shows that many companies removed from the S&P 500 index outperform the market. A key study by Research Affiliates found that stocks taken out of the S&P 500 between 1990 and 2022 outperformed those added by over 5% annually in the five years afterward. The study’s authors argue that this outperformance is partly due to the immediate undervaluation of outcasts caused by excessive selling after removal. These and other researchers speculate that this pattern is mainly triggered by the recognition that additions are overpriced and deletions are undervalued. Heavy buying activity eventually leads to a situation where companies added to the index trade on inflated price-to-earnings ratios, causing investors to sell them.The market has a tendency to throw a parade for S&P 500 additions while holding a funeral for removals. This emotional overreaction often creates prospects for investors. Stocks kicked out of indexes tend to be excessively punished by the market after the initial decline. However, over time, they recover and can provide better returns as the market corrects its overreaction. Some companies bounce back as contrarian investors step in, finding value in these beaten-down stocks.
There’s another reason stocks dumped by the S&P 500 might be counterintuitively doing well afterward. People on Wall Street tend to repeat claims about an ‘index effect’ that’s no longer operative. If it’s not true that those joining the index see much of a bump in their stock price in the first place, then those leaving it will often have a better performance, all else being equal. Joining the S&P 500 should profoundly influence share prices considering its role in modern investing. The world’s most widely tracked index has trillions of dollars invested in funds that track its performance. Anyone who joins it sees their stock bought up by hundreds of index funds and exchange-traded funds (ETFs). When a stock gets removed, those funds must sell it, creating significant price swings. Getting removed from the S&P 500 is a very public demotion, potentially affecting everything from employee morale to customer perception. Being in the S&P 500 is like having a spotlight on your company, bringing increased visibility, media coverage, and analyst attention. Companies that join the index often see a boost in their public image and credibility. On the other hand, being removed from the index can be seen as a red flag that a company is old news, leading to a snowballing of negative sentiment and lower investor confidence. One study found that if you created an index of the S&P 500 outcasts and invested in them from 1991 to the end of 2023, your gains would have been an average annual rate of 14.0% versus 10.6% for the S&P 500. $100 invested over those 33 years would become about $7,500 in the outcast index (neglecting commissions, taxes, and fees). If you stuck with the ‘winners’, you’d have about $2,800 from investing in the S&P 500 index. It’s said to be inevitable that removal from the S&P 500 will cause a company’s share price to fall, especially in the initial few months. For that reason, various pundits recommend steering clear of these stocks, including CNBC’s Jim Cramer.Jim Cramer cautions against attempting to catch a bottom on stocks that are removed from the S&P 500, stating that historically, the odds are against such investments. He suggests that if Standard & Poor’s doesn’t want them, investors probably shouldn’t either.
The ‘Index Effect’ and Falling Knife Phenomenon:
According to research from the National Bureau of Economic Research, in the 1980s and 1990s, stocks added to the S&P 500 experienced strong, positive, and abnormal returns of about 3.4% and 7.6% respectively. Conversely, stocks removed from the index saw steep declines of about -4.6% in the 1980s and -16.6% in the 1990s. The S&P 500 index is rebalanced quarterly, typically on the third Friday of March, June, September, and December.
Decline in Index Effects in the 2000s:
However, studies from the 2000s indicate a significant decline in these effects. By the 2010s, stocks added to the index only saw a small rise of 0.8%, with some studies showing a minuscule 0.1% increase. Stocks removed from the index had almost no abnormal returns, at -0.6%. In the 2020s, the differences between being in and out of the index seem to be statistically insignificant.
Reasons for the Decline in Index Effects:
Several factors have been suggested for this decline:
– Market efficiency: The market has become more efficient at accommodating demand shocks created by index changes. Institutions provide liquidity more effectively, reducing price pressure.
– Increase in migrations: A large percentage of index changes involve companies moving between the S&P MidCap 400 and the S&P 500, rather than completely new companies being added or removed. This causes offsetting trades from index-tracking funds, leading to smaller net demand shocks.
– Predictability: With the growth of indexation, index changes have become more predictable, allowing arbitrageurs to front-run index announcements. This anticipatory trading reduces the price impact when the actual change occurs.
– Market liquidity: Liquidity in the stock market has improved considerably, with bid-ask spreads falling significantly. This increase in liquidity allows the market to absorb large trades more efficiently, further reducing the price impact of index changes.
Purpose of S&P 500 Index Adjustments:
The S&P 500 is designed to represent the largest and most influential companies in the U.S. economy. To maintain its status, the index must adapt to market changes by adding companies that better reflect the economic landscape and removing those that no longer meet the criteria. This selection process is overseen by a committee at S&P Global, which meets quarterly to evaluate companies in the index and make adjustments as needed.
Changes to the S&P 500 index are typically announced with several days’ notice to give index funds and other market participants time to prepare. A company must meet several requirements to be considered for the S&P 500: An unadjusted market cap of at least $18 billion. At least 10% of shares are available to the public. Have positive earnings in the earlier four quarters. Adequate liquidity. Be a U.S. company. Be a publicly traded company for at least 12 months. Contribute to the balance of sectors held within the index. Meeting these requirements doesn’t guarantee inclusion; the S&P 500 committee exercises discretion to ensure selected companies are truly representative of the large-cap U.S. market. Immediate action can be taken if a company is taken over, delisted, or files for bankruptcy, in which case the stock would be removed from the S&P 500 and replaced with another company.
Previously, stocks removed from the S&P 500 did better than in the last decade, at least in terms of outperforming the index. This is mainly due to the outsized performance of tech stocks included in the index and rotation away from value investing. Now, let’s look at some stocks removed from the S&P 500 that have outperformed the index. As of market close on Nov. 6, 2024, here are a few standouts with share price performance data: Zions Bancorporation N.A. Removal date: March 18, 2024. Share price performance since exclusion: 52%. S&P 500 performance since exclusion: 15%. Sentiment in regional banks took a hit in 2023 after Silicon Valley Bank and First Republic went out of business. Salt Lake City-headquartered Zion Bank got caught in the crossfire, shedding value and eventually getting kicked out of the S&P 500. However, Zion’s downtrend was short-lived. An improving economic outlook and the U.S. Federal Reserve’s move to cut interest rates have boosted the sector and Zion. In fact, Zion’s stock began its rally around October 2023 when news started spreading that it may get the boot. Lincoln National Corporation. Removal date: Sept. 18, 2023. Share price performance since exclusion: 42%. S&P 500 performance since exclusion: 33%. A challenging couple of years for Lincoln Capital led its share price to plummet and market cap to fall way below the S&P 500’s threshold. The life insurer was affected by Silicon Valley Bank’s collapse. It also faced an uptick in pandemic-related mortalities and other challenges, weighing on its balance sheet and leaving it in a precarious financial position. The company has since been in recovery mode. Business has been improving, management has a better handle on costs, and investors have begun to notice, bidding the once-downtrodden shares up significantly over the past year. Lumen Technologies Inc. Removal date: March 20, 2023. Share price performance since exclusion: 262%. S&P 500 performance since exclusion: 51%. Lumen Technologies has come a long way since getting booted from the S&P 500 in March 2023.A telecom company that once focused on expanding its wireline business through mergers and acquisitions, shunning the wireless market, found itself burdened with debt. This led to the suspension of its dividend, causing shareholders to flee, a decrease in market capitalization, and ultimately, the loss of its S&P 500 status.
2223Lumen is now actively enhancing its enterprise offerings, concentrating on large and midmarket enterprises in North America, and using new partnerships to support AI network capacity. The surge in artificial intelligence (AI) and several contract wins, including one with Microsoft Corp. (MSFT), have boosted sales and reignited cautious investor optimism about the company’s future. PVH Corp., removed from the S&P 500 on Sept. 19, 2022, has seen its share price increase by 86% since exclusion, outperforming the S&P 500’s 54% performance in the same period. Known for its cyclical nature and volatility, PVH owns brands like Calvin Klein and Tommy Hilfiger and has faced challenges such as shifting consumer preferences, rising post-pandemic interest rates, and broader issues in the retail clothing sector. With falling borrowing costs and easing recession fears, investors are regaining interest in the company and its diversified portfolio of popular brands. The company’s global reach, cost discipline, technology investments, and low valuation have also contributed to the revived interest in its stock. Apartment Investment and Management Company, removed on Dec. 21, 2020, has experienced a 79% share price increase since exclusion, compared to the S&P 500’s 61% performance. This real estate investment trust acquires, manages, and redevelops residential apartments, benefiting from increased real estate demand and falling interest rates. The S&P 500 can add or remove companies at any time, with rebalancing occurring quarterly. However, the committee has the authority to make changes outside of these scheduled times, such as when a company is acquired or delisted. Stocks removed from the S&P 500 in 2024 include American Airlines Group (AAL), Etsy Inc. (ETSY), Bio-Rad Laboratories (BIO), Robert Half Inc. (RHI), Comerica Inc. (CMA), and Bath & Body Works Inc. (BBWI). Stocks added to the S&P 500 in 2024 include Amentum Holdings Inc. (AMTM), Palantir Technologies Inc. (PLTR), Dell Technologies Inc. (DELL), and CrowdStrike Holdings (CRWD). The number of companies that fall out of the S&P 500 each year varies, with no fixed number.In 2024, 12 companies were removed from the S&P 500. In 2023, 15 companies got the boot. The Bottom Line: When a stock is removed from the S&P 500, some investors may think of exiting. However, this knee-jerk reaction could mean leaving money on the table. Conventional wisdom suggests avoiding these corporate outcasts, but historical data shows a surprising twist. Companies removed from the index often stage impressive comebacks and overall outperform the market by up to 5% annually in the five years following removal. This counterintuitive pattern highlights a fundamental principle of investing. The best opportunities often emerge when everyone else is running in the opposite direction. Getting booted from the S&P 500 can trigger automatic selling by index funds and negative headlines, but it can also force companies to make tough but necessary changes. These stocks often trade at much lower prices than their previous highs, meaning less optimism is priced in and there’s more potential upside if the company turns things around.