J.C. Penney Gets Kicked to the Curb

For nearly 60 years, J.C. Penney (NYSE: JCP  ) has been a fixture of the S&P 500, one of the original founding companies of the stock index when it was created in 1957. But after a tumultuous two-year period that has seen the retailer lose more than two-thirds of its value, the folks who run the index no longer see it as indicative of large-cap stocks and are removing it from the iconic market barometer. In its place will be Allegion, the home security business being spun off from Ingersoll-Rand at the end of the month.

With a market cap of $2.8 billion, Penney will drop to the S&P MidCap 400 Index, replacing Aeropostale (NYSE: ARO  ) , which itself has fallen on hard times, losing 25% of its value over the past year but down 40% from its 52-week high. Things are so bad there that one of its largest shareholders, Crescendo Partners, just said the teen retailer ought to hang out a shingle and sell itself.

As the index shuffle will occur on Friday, November 29, after the market's close, don't be too surprised to see the department store's stock experiences some volatility, though the timing is done to minimize the impact. All those mutual funds that hold Penney in their S&P 500 portfolios will be forced to sell the shares, but those that track the MidCap 400 will be buying. I think Penney's stock is a buy as well. 

Penney's third-quarter earnings report had a lot going for it that indicates its turnaround plan is working, though plenty of risks remain. Same-store sales are moving in the right direction as is store traffic as a result of the doorbuster sales strategy that has proven popular with shoppers who fled the retailer in droves when it abandoned the policy.

It was also able to generate enough cash to pay off $200 million on its revolving credit facility, a sign that its financials are somewhat improved. Sure, Penney is still saddled with a mountain of debt and it did a capital raise right after telling investors it didn't need to, but as distasteful as that move was, the retailer now has a bit of a cash cushion that gives it some breathing room to effect further changes on its road to recovery.

No doubt, the turnaround is not a slam dunk; in fact, it's still a risky play. Any change for the worse in the economy, for example, could doom consumer confidence and suddenly have them draw their purse strings tighter. Yet those risks have been largely priced into the stock at this point so the upside potential is far greater. Certainly, CEO Myron Ullman thinks so as he just bought a $1 million tranche of stock on the open market.

On average, there are 20 or stocks added to and deleted from the S&P 500 every year, and with Penney's exit -- along with Sears Holdings' removal last year -- only two department stores remain: Macy's and Nordstrom. It was only a few short years ago that the former was itself considered to be in danger of bankruptcy, swamped with falling sales and large amounts of debt, but it has since corrected its problems and turned itself into one of the leading retailers again. I see a similar renaissance for its troubled rival.

Penney's stock is almost 50% higher from its recent lows, a remarkable achievement built on confidence that the retailer has identified what is wrong and is moving to fix it. And, no doubt, a good dollop of short covering gave it a boost as from investors who bet (wrongly) its earnings report would be a disaster covered their positions. That there were no surprises in the report was perhaps the biggest surprise for many.

A study published in the Journal of Banking & Finance this summer found that since 1962, stocks that were both added to and deleted from the index enjoyed great price appreciation, perhaps indicating the upward mobility of the market in general, but the increased performance was much more profound long term on those that were cut from the list. The authors suspect it's because companies are added at their peak of performance and aren't able to sustain it, while those deleted are in decline and go on to effect a turnaround.

That would seem to encapsulate what's at work with J.C. Penney, and investors shouldn't worry about what effect this transient event will have.

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