NEW YORK (Real Money) -- You know why it is so tough to beat the S&P 500? Because it's always outdoing itself, getting better and better with each change.
The combination of new picks from the S&P mid-cap group that have outgrown their compadres and the deletion of stocks that have shrunk in size or have been acquired at a big premium is a very compelling combination. It's as if the S&P mid-cap is the farm team, the minor leagues, and when that index produces phenoms they get promoted to the Bigs to replace either washed-up, second-rate performers or inductees to the S&P Hall of Fame because they received hefty takeover bids.
We saw the classic example of this just last Friday night when Equinix (EQIX - Get Report), SL Green (SLG - Get Report), Henry Schein (HSIC - Get Report) and Hanesbrands (HBI - Get Report) replaced Denbury Resources (DNR - Get Report), Nabors (NBR - Get Report), Avon Products (AVP - Get Report) and Carefusion (CFN).
Consider these like trades. Equinix is in one of the hottest portions of the U.S. economy, the data center business. As data as a category grows by leaps and bounds, Equinix has driven to become best in class and while, initially, there was a belief that it didn't have enough that was proprietary, it's proven time and again to be the warehouse of choice and is in incredible demand.
Compare that with Denbury Resources, a totally down-and-out leveraged oil and gas company that is struggling mightily with these lower oil prices. In fact, it is one of those that I would say, if oil doesn't go higher, might have a real chance of not making it in its current structure. Maybe there's some synergy with its stock symbol, DNR -- Do Not Resuscitate. It drops down to the minors, the S&P MidCap 400, the graveyard of the losers and the fertile ground for the next winners in the S&P 500 roster.
Then there's SL Green, one of the best real estate investment trusts in the country and owner of the highest-quality office real estate in the New York Metropolitan area, a vicinity with rapidly rising rates, low vacancies and tremendous employment growth.
The castoff that makes room for SL Green? Nabors. This company, at one time, was the premier land driller in this country. Nabors has some of the best technology and has historically been a favorite of the natural gas industry. It also had 48 offshore oil rigs around the globe. Now, consider these two businesses. Oil companies have been able to cut down the time it takes to drill a well and have driven the drillers to take a much lower price on the current jobs, some of the fees being cut by one-third because of the collapse in drilling. The rig count in this country, as maintained by Baker Hughes, has declined for 14 straight weeks and has now fallen an astonishing 46% than the peak just last October.
Worse: offshore rates are collapsing, as you know, from the declines in Transocean (RIG - Get Report), Seadrill (SDRL - Get Report), Diamond Offshore (DO - Get Report) and Ensco (ESV). This one may be among the least desirable in the entire godforsaken industry.
Then there's Hanesbrands. This is one of my absolute favorites, an acquisitive company, having gathered Champion, Maidenform and Playtex along the way, always driving down costs and becoming the preeminent undergarment company. It manufactures the goods itself, which has helped it maintain quality. A recently-executed four-for-one split seems to have fired up the faithful as the stock's been on a tear, up 16% this year. There's plenty of room for more acquisitions and it's got the best growth of any apparel company.
The loser that makes way for Hanes? One of the worst companies I have come across, the totally bedraggled, confused and troubled Avon. I have to admit that when Sheri McCoy came over from Johnson & Johnson (JNJ), I thought the company's woes could be solved. But it sure doesn't seem that way. The last quarter was a distinct disappointment, acknowledged by the CEO to have progress "that was slower than I would have liked." Total revenue decreased 12%, but to be fair, this one is uniquely disadvantaged by the strong dollar because it would have been actually UP 5% ex-currency. Of course, the issue is when you have that much currency movement is that you have to say, "wow, that's still horrendous despite the adjustment." Cash flow of from operations for 2014 declined a massive $180 million and Avon had to pay $68 million to the Justice Department as part of a settlement for Foreign Corrupt Practices Act violations. The company's projections for 2015, plus its $1.6 billion in debt, makes this a nightmare for any portfolio manager.
Then there's the final addition: Henry Schein, perhaps one of the single-most-consistent health care concerns in the entire world. It's recording high-single-digit growth as a supplier of dental and vet supplies and it has a moat around its business that Warren Buffett would covet. It's just a terrific company with fantastic management and its last beat and raise was among the finest so far of 2015.
Leaving the S&P? Carefusion, another great company that snared a bid from Becton Dickinson (BDX - Get Report) that carried a 26% premium. So, before this stock would leave the S&P, it gave a nice boost to the index.
The changes I wrote about in Part 1 are very typical of the upgrading that goes on within the index all of the time. For example, earlier this month Skyworks Solutions (SWKS - Get Report) replaced Petsmart (PETM). The latter got a terrific private equity bid and the former may be among the hottest semiconductor companies out there, levered to the cellphone NOT the personal computer.
In January, HCA (HCA - Get Report), the giant hospital company and biggest beneficiary of the Affordable Care Act, took the place of Safeway, which got a big bid from the privately-controlled Albertson's.
Then like Henry Schein for the acquired Carefusion trade, Endo International (ENDP - Get Report), right up there with the red-hot Actavis (ACT) and Valeant (VRX) and currently vying for Salix against Valeant, subs for Coviden, which struck gold in its merger with Medtronic (MDT - Get Report), getting a 29% premium bid from the device company. The changed tax status has only enhanced the value of Medtronic, as it now pays much less via the tax inversion that Medtronic availed itself of before the change in the laws.
On Dec. 4, the fast-growing travel company Royal Caribbean (RCL - Get Report) replaced the plodding Bemis (BMS), a packaging concern. In November, Level 3 (LVLT), a content distribution company that many thought wouldn't make it after taking down so much debt in the late 1990s, replaced Jabil Circuit (JBL - Get Report). This is another one of those sub rosa upgrades because Jabil, which was once a very-fast-growing contract manufacturer, has had stalled and halting growth for years while Level 3 is benefitting from the Netflix (NFLX - Get Report) revolution.
Or take the changes from Nov. 8, 2014, when Mallinckrodt (MNK - Get Report), one of the fastest-growing and most acquisitive drug companies, itself a spinoff of Covidien, subbed for Rowan (RDC). What a monumental change this has been, as MNK keeps filling out its franchise and has already risen 25% this year. Rowan's been a disaster since it left, as befits a contract oil drilling company with gigantic drill ships in its portfolio. The surfeit of those is legion, hence why its stock has cratered 22% this year. You have to wonder, with that switch, how PASSIVE the S&P 500 really is. That isn't luck.
Finally, let's consider the case of the switches on Sept. 19, 2014, when the S&P added two companies: United Rentals (URI - Get Report), a construction-related company with a business model that makes it much more advantageous for small businesses to rent, rather than buy, equipment and Universal Health Services (UHS - Get Report), an acute hospital chain that's also a big beneficiary of the Affordable Care Act.
They replaced two companies that almost no portfolio manager would care for, Graham Holdings (GHC - Get Report), which is a vacuum and heat transfer manufacturer that was left behind when Graham sold the Washington Post to Jeff Bezos, scoring a big gain before it exited, and Peabody Energy (BTU - Get Report), one of the largest coal companies on earth when that fuel has become Public Enemy No. 1 worldwide. No wonder its stock is down 29% for the year. Graham's also down 14% for the year. United Rentals hasn't been a standout this year, down 13%, but United Health has gained 2.5%. More importantly, these two are huge quality upgrades vs. Graham and Peabody.
I can go back for years and see this pattern over and over again: spent names being sent down to the minors, or big winners where the takeover accrued to the index, being replaced by rising stars with many good years ahead of them. It's a model that works and it explains much about why it's tough to beat the S&P, because the darned thing upgrades in constant fashion in an active, not at all passive, form despite its reputation for brainlessness.
In short, it's anything but. No wonder no active mutual fund can beat it consistently. It's about as active as it can be with the best farm team, the smartest retirement system and a fabulous exit strategy for the best of the best.