All the finger-pointing about last year's debacle in the two leading U.S. stock market indices may have overlooked a couple of guilty parties: the compilers of the indices themselves.

A close look at the performance of the companies that Standard & Poor's added and subtracted from its benchmark S&P 500 index for reasons other than mergers or spinoffs, for instance, shows that inglorious stock picking and an ill-timed move to add more technology may have contributed at least as much to the sharp decline of the index as did deteriorating business conditions.

The S&P 500 is often mischaracterized as a passively managed index of large stocks, but in 2000, its managers became seriously aggressive -- adding (and subtracting) four new stocks each month, on average. In the process, the index was systematically stripped of small and mid-sized value stocks from Jan. 28 to Dec. 11 in favor of large-cap growth stocks -- largely from the technology sector, and at exactly the wrong moment.

You didn't know that stocks are sometimes removed from the index for subjective reasons, just as they are at any ol' mutual fund? It's strange but true. In a document titled "S&P index Methodology" at its Web site, Standard & Poor's says it removes a company from its flagship index when it is merged out of existence, files for bankruptcy or restructures in such a way that the core business is spun off into a separate entity or is "no longer representative of its industry group." The document adds that "lack of representation" can also include situations in which a company "could be in an industry that has declined in economic importance because of technology obsolescence."

The In-Crowd and the Outs

Unfortunately for the nation's millions of S&P 500 index investors, "obsolescence" is in the eye of the beholder. Last year, it meant:
  • Of the 19 stocks removed from the index for reasons other than mergers, only one was a tech stock -- workstation maker Silicon Graphics (SGI).
  • Of the 47 stocks added to the index for nonmerger or spinoff reasons, 24 were tech stocks.

As fate would have it, the expelled companies had the last laugh on index investors -- they powerfully outperformed the S&P 500 as a group.
  • The "Purged 19" went on to gain 44.5% on average from the date of their expulsion through Feb. 12. They were led by a 259% advance by Armstrong Holdings (ACK), a 172% advance by Crown Cork & Seal (CCK), a 173% advance by Owens-Illinois (OI), an 89% advance by Foster Wheeler (FWC) and a 73% advance by Nacco Industries (NC). Just six of the expelled stocks failed to advance after getting the boot.
  • The "Added 47," in contrast, declined 15.5% on average from the date of their addition through Feb. 12. The worst were Conexant Systems (CNXT), down 80%; Sapient (SAPE), down 73%; BroadVision (BVSN), down 69%; JDS Uniphase (JDSU), down 70%; Power-One (PWER), down 69%; and Broadcom (BRCM), down 63%. Only 18 added stocks had advanced since their elevation, and just two of those were techs: Linear Technology (LLTC) and Symbol Technologies (SBL). The best new addition was independent power producer Calpine (CPN), up 28%.

The contrast between the adds and purges is sometimes dramatic when you look at relative performance between stocks that were swapped for each other.
  • On June 2, scientific-instruments maker Agilent Technologies (A) replaced strip-miner/forklift maker Nacco. The New Economy stock is down 36% since then, while the Old Economy stock is up 69%.
  • On March 31, a couple of weeks after the Nasdaq peak, data-storage software maker Veritas Software (VRTS - Get Report) replaced auto-parts retailer Pep Boys (PBY). The former is down 45% since then, while Pep Boys has gained 6%.

The add-drop differential was similar but less dramatic at the nation's other leading index, the 30-stock Dow Jones Industrial Average. Dow Jones adds and subtracts stocks much less frequently than Standard & Poor's. The last changes came Nov. 1, 1999, when Intel ( INTC), Microsoft ( MSFT), Home Depot ( HD) and SBC Communications ( SBC) were added and Sears ( S), Chevron ( CHV), Goodyear Tire & Rubber ( GT) and Union Carbide were removed.
  • On average, the stocks added by Dow Jones declined 16% through Feb. 12, while the purged stocks declined just 0.8%.
  • The surprise leader among all eight -- and the only one that advanced at all -- was Sears. It's up 47%.

How the Picks Are Made

What should we make of all this?

It's clear at the very least that the sophisticated committee members in charge of S&P 500 index changes are not a whole lot different from the average private investor when it comes to portfolio management. Very often, it seems, they reach a point of maximum frustration with a stock or industry just when it is finally poised to go up. And this is exacerbated by the huge amount of power they control. When they point an icy finger of death at an already battered stock in their portfolio, the managers of some three-quarters of a trillion dollars in mutual and pension funds chartered to mimic the S&P 500 index exactly must sell that stock willy-nilly, regardless of their views of its value. By the time all that selling is done, it often (but not always) gets so cheap that there's almost nowhere to go but up.

Elliott S. Shurgin, the head of the nine-person Standard & Poor's committee that governs the S&P 500 index, was surprised Tuesday to learn how well the expelled companies had done, and acknowledged that his organization's timing could have been better. But he argued that S&P seeks "to be reflective of the market -- we're not trying to beat the market." As growth-style companies roared into favor in the late 1990s, many Old Economy stocks like Pep Boys or Nacco Industries shrank in market capitalization to the point that they were "outliers" in an index chartered to hold large-cap stocks. As outliers, he said, they needed to be removed.

He said he preferred to call the process of choosing their replacements "an exercise of qualitative judgment" rather than "stock picking." "If you are more comfortable with a purely rules-based index, you should look at a Russell 1000 or a Wilshire 5000," he said.

The Real S&P 500 Effect

By now, most investors know that a stock invariably rockets up in price following an announcement that it will be added to the S&P 500 index. Most of this so-called S&P 500 Effect tends to occur in an untradeable gap between the time of the after-hours press release and the open of trading the next day. And it's largely due to the very reasonable expectation that hundreds of mutual funds chartered to mimic the index are about to be forced to buy the stock regardless of its true value.

So perhaps now we can postulate an "Anti-S&P 500 Effect" that takes place when stocks are removed from the index. And the good news is that this is a market anomaly that, in the past year at least, was thoroughly tradeable.

To take a stab at profiting from the next round of expulsions, I ran a screen of S&P 500 stocks and sorted it by market capitalization. I took the 16 that had a market capitalization of less than $1.25 billion and sorted them by price-to-book ratio. For my S&P 500 Purge Watch list, I chose the 10 with the lowest P/B multiples. I'll track them as a recommendations list for the next year, available from the sidebar at left. If you want to try this at home, do not start the clock ticking on the recommendation until the stock is actually removed from the index because it will probably decline a great deal after any potential expulsion announcement.

S&P 500 Purge Watch
Company Market Capitalization Price/Book Value
American Greetings (AM) 778,973,249 0.66
Louisiana-Pacific (LPX) 1,145,980,000 0.85
Timken (TKR) 936,280,823 0.92
Ryder System (R) 1,138,089,191 0.93
Cooper Tire & Rubber (CTB) 933,564,052 0.97
Potlatch (PCH) 883,066,845 1.04
Thomas & Betts (TNB) 1,195,960,049 1.19
McDermott International (MDR) 967,264,000 1.21
Worthington Industries (WOR) 882,777,513 1.33
Longs Drug Stores (LDG) 983,841,589 1.46

At the time of publication, Jon Markman owned or controlled shares in the following equities mentioned in this column: JDS Uniphase, Microsoft and Intel.

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