Rule Maker Portfolio
The S&P 500 is an Index, Nothing More

By Bill Mann (TMF Otter)

ALEXANDRIA, VA September 13, 1999 -- Friday's Rule Maker column made an interesting point in regard to limiting Rule Makers to companies that reside in the S&P 500. The question was posed whether inclusion as one of the 500 companies in the index should be a requirement for a company to be considered for a Rule Maker investment.

To this question I would have to say no. There are many aspects of a Rule Maker company that are in common with those shown by S&P 500 components, including large market cap, high gross revenues, profitability, and stability. By definition, the Rule Maker companies are the market leaders in their given industries, and unless that industry is plastic army men manufacturing or non-nutritional cereal varnish, in all likelihood they are included in the index. But our own T. Rowe Price, for example, is not.

Let's look at what the S&P 500 is not. It is not, for example, an index of the 500 largest American companies, but rather 500 of the largest. Several of the largest 500 market cap companies are not included for reasons discussed in Friday's article. Further, the index is also not all encompassing, since it limits itself to U.S.-based companies. The Motley Fool does not generally recommend looking overseas for investment opportunities because of a general lower standard of financial reporting than required by the SEC (Securities and Exchange Commission). But I would be hard pressed to think of more dominant industry leaders than DaimlerChrysler (NYSE: DCX), Nokia (NYSE: NOK), or Sony (NYSE: SNE) -- none of which are included in the S&P 500.

The S&P 500 is also, despite what we may have been led to believe, not scientifically generated. There, of course, is a science of metrics involved, but it is stated policy of Standard & Poor's to ignore the exact nature of these metrics in order to keep the list consistent. This is not a bad thing, for if the list were to change by 50 companies a month, it would be much more difficult to do a comparative performance analysis.

Standard & Poor's chooses to maintain stability in the list rather than cycle companies in and out based upon fluctuations. By nature, the index is significantly reactive in its selection of companies. For a broad-based index, this is a good thing, but with Rule Makers we are looking for the BEST companies in their respective industries. If you find a company that meets the Rule Maker criteria and is not listed on the S&P, doesn't it seem just a little goofy to eliminate it from consideration?

In the spirit of Monday crankiness, I'm going to try to debase the two rationales mentioned Friday for limiting Maker selections to members of the S&P 500.

Pause for a sip of coffee to balance the humors� good. Let's look at those precepts.

1) Well-chosen Companies

We can all agree that the companies in the S&P form the backbone of American commerce. But take a good look at the second word in that heading. "Chosen" is exactly the right word for the S&P 500, because it is a managed group of companies. The criteria for company inclusion and the relative weight of each factor has been determined by human beings, not nature. I know this is high treason for a Fool to say, but in effect the S&P is no different in its composition than a managed mutual fund, except that the index does not play the role of investment manager.

There is no argument here that the people managing the index are smart and know what they are doing. But isn't this the same thing we Fools expect from ourselves in individual stock selection? I'm sure mutual fund managers are smart, but Fools of rational independent thought are fully capable of making the same determination of investment values themselves. This is neither a slap at Zeke Ashton, nor a criticism of Standard & Poor's index managers; rather it is a statement of the power of Foolishness to make an unencumbered analysis as to whether a company meets the standard of Rule Maker in its industry.

2) Index Buying Power

The basis of this argument is that component companies in the S&P 500 have critical market mass because funds tracking the index are forced to buy them in increments relative to their proportionate market cap to the total cap of all companies in the index. This is indeed true, and companies see enormous increases in their share prices when they are added to the index, as portfolio managers are suddenly forced to buy them.

But we Fools are not so interested in the short-term price moves of a stock as much as its long-term potential to return value to us. Do we seek to "play" the market? Only inasmuch as the market under- or over-values certain securities. So what does inclusion or exclusion in any index mean for the fundamentals of a company? Not one thing. Nada. Niente. For this very reason, Warren Buffett, Chairman of Berkshire Hathaway (NYSE: BRK.A), is ambivalent about having his company added to the 500, even though in terms of market cap it is among the top 20 American companies. If Berkshire Hathaway were included, its share price would naturally skyrocket, but the increase would be, in his eyes, artificial, and not based upon any rise in the intrinsic value of the company.

So get out there, meet your Makers. If you think you've found one, check the S&P 500 list, and if it's not on there, ask yourself why. But if you're convinced of its status as the King of the Hill, don't be afraid to deviate on the side of Foolishness.

Party on, Garth.

Foolishly I am,

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Correction: In Friday's report, it was incorrectly stated that our Yahoo! holding is underperforming the market. As of Friday's writing, Yahoo! was indeed outperforming the market since our February purchase. Obviously, the swings in Yahoo!'s stock can be fast and furious. In fact, when the report was originally penned two weeks ago, we were essentially flat on our investment. Since then, Yahoo! has had quite a run. We apologize for any confusion.