By Sean Hannon, CFA, CFP, of EPIC Advisors from Covestor.com.
A well-known trading strategy involves buying companies before they are added to the S&P 500 and shorting companies that are being removed from the index. Since so much money is invested either directly in index funds or with money managers who attempt to mirror the index's performance, additions and removals from the S&P 500 offer wild price swings that are dislocated from business fundamentals.
As a value investor, I welcome this dislocation as an opportunity to buy stocks cheaply. A recent example of the S&P effect is Transocean (RIG - Get Report), the largest offshore driller of oil and natural gas in the world. With a high level of demand, RIG has excellent earnings visibility and a strong backlog of future business.
Typically, the market would pay a premium for high visibility. Last May, the shares were trading above $161, and the premium was evident. At the current price level of $52, that premium is gone, and the shares are now being offered to opportunistic investors.
Three main problems have combined to knock the share price lower. The first two are transient. With the expectation of higher corporate income-tax rates under the Obama administration, RIG decided to move its base to Switzerland. Doing so made the company ineligible to remain in the S&P 500. Forced selling by index funds caused the shares to drop swiftly.The second issue concerns the large decline in oil prices. Since RIG is hired to extract oil from harsh locations, many felt its profitability and backlog would suffer. I view this outcome as unlikely. Most of the projects RIG operates are long term in nature and require substantial capital investment. I find it improbable that an energy producer would curtail an existing project for which it has already allocated capital. A sustained period of very low energy prices could hurt the shares. However, that issue is three to five years down the road and should not drastically affect today's stock price. After all, with a current P/E of 3 and a market capitalization that is 40% of current backlog, management could use the earnings and cash flow to finance an LBO.