Is the S&P 500 Committee Giving Investors a Gift?

The S&P 500 is generally viewed as the benchmark for the US stock market. But is the committee responsible for selecting its members actually good at picking stocks?

History suggests the answer may be no.

In a previous SVA Focus, Ross Healy examined the committee’s tendency to add companies after they have already experienced significant price appreciation, while removing companies after their shares have fallen out of favour. In other words, the committee often appears to buy near the top and sell near the bottom.

Recent changes to the index suggest that pattern may be repeating itself.

The Hidden Opportunity in S&P 500 Deletions

Research conducted by Rob Arnott of Research Affiliates found a significant valuation gap between companies added to the S&P 500 and those removed from it.

The companies being added tend to be popular, strongly performing and richly valued. The deleted companies are often struggling, inexpensive and deeply out of favour.

According to Arnott’s research, additions historically underperformed the index by approximately 1% to 2% annually. Deletions, meanwhile, outperformed the index by an average of approximately 5% per year over the following five years.

That does not mean every deleted company will become a successful investment. However, it suggests that index removals may provide an interesting hunting ground for value-oriented investors.

This brings us to Campbell’s Company, formerly known as Campbell Soup Company.

Campbell’s: Out of Favour, but Potentially Undervalued

Campbell’s shares have experienced a substantial decline, leaving the stock trading near its SVA high conservation price.

That is a dramatically different valuation picture from the stocks currently being added to the index.

Campbell’s also offers a dividend yield of approximately 6.8%. Its balance sheet remains sound, with a five-year compound growth rate of slightly more than 6%.

Most importantly, SVA analysis indicates a gap of approximately 85% between the company’s current share price and its fair market value potential.

The stock has also begun moving back above its high conservation price, which may indicate that investor sentiment is beginning to stabilize.

Campbell’s is not a high-growth technology company. It is a mature consumer business that has been heavily sold and largely abandoned by investors. But at the right valuation, even an unexciting business can become an interesting investment.

What Is the Committee Adding?

One of the companies being added to the index is Marvell Technology.

Marvell has a strong balance sheet, but its five-year compound balance sheet growth rate has been below 6%. Based on SVA valuation measures, the stock would need to decline by approximately 66% to return to its fair market value.

Its forward price-to-earnings ratio is also close to 53 times.

That does not necessarily mean Marvell is a poor company. It does, however, suggest that investors are already paying a substantial price for its expected future growth.

The committee is also adding Flex, formerly known as Flextronics.

Flex has delivered stronger balance sheet growth of approximately 22% annually over the past five years. However, as with Marvell, much of the company’s strength was already reflected in its share price before it was selected for inclusion in the index.

Once again, the S&P 500 committee appears to be adding companies after strong performance while removing a company after a major decline.

A Potential Gift for Value Investors

Campbell’s is trading near its high conservation price, offers an attractive dividend yield and appears to have considerable fair market value potential.

Meanwhile, the companies replacing it have already enjoyed significant market strength and trade at substantially higher valuations.

The S&P 500 committee may believe it is removing a weak performer. From a valuation perspective, however, it may instead be pointing investors toward a promising opportunity.

Sometimes the stocks being thrown out of an index are more interesting than the stocks being welcomed in.

That may be the real lesson behind the latest S&P 500 changes and, in the case of Campbell’s, some valuable food for thought.

Watch Ross Healy’s full SVA Focus analysis:
https://youtu.be/LfYsj_d5Cwg

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