How Indexes Affect Companies

In this week's episode of Industry Focus: Tech, host Dylan Lewis and Motley Fool contributor Evan Niu explain what it means to be a member of the index club. Tune in to find out the difference between the Dow and the S&P 500, and why we usually focus on the S&P 500; what it takes for a company to be included in the S&P 500 today, and how that's changing; what benefits and drawbacks there are to being included in an index; how index makers are putting their foot down to try and slow down shareholder-unfriendly voting structures; and more.

A full transcript follows the video.

This video was recorded on Feb. 7, 2018.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, Feb. 9, and we're talking about the perks of being in the in crowd. I'm your host, Dylan Lewis, and I have fool.com tech specialist Evan Niu on the phone. Evan, what's going on?

Evan Niu: Not much, doing well. How about yourself?

Lewis: I'm doing OK. Listeners might notice there's a slightly different intro there. I almost tripped up over it as I was going through. I did not say Skype. We're trying out a new service today. One of our listeners, Patrick Befumo, actually suggested it. If things sound good, listeners, big thanks to Patrick. If not, we will continue to try in our ongoing pursuit to give you audio perfection by way of Austin Morgan. But, I'm very excited -- I'm very excited just to hear you better, frankly, Evan.

Niu: [laughs] Let's hope it sounds better.

Lewis: I think it's going to be great. Today, we're talking about what it takes to be included in a major index and why it's important. Evan, everyone has their own take on this, but if you ask me, the S&P 500 is the definitive gauge for what's going on in the overall U.S. stock market. I'm not a Dow Jones guy.

Niu: I hate the Dow. I know that's kind of strong language for a stock market index. But I think people pay too much attention to it, and it's not very representative. I don't really like the methodology of being price weighted. So, I typically ignore it, even though, obviously, the rest of the financial media always blasts headlines when the Dow reaches this milestone or that milestone. But I think it's a pretty dumb index, frankly.

Lewis: And I will say, even here at the Fool and fool.com, we are guilty of writing those headlines talking about the Dow hitting certain milestones. [laughs] That's worth noting. Evan, you mentioned price-weighted. Why don't we talk about the difference, the main difference, in my view, between the Dow and the S&P, price weighted vs. market cap weighted indices?

Niu: The Dow is price-weighted, so each stock in there is weighted based on its individual share price. But, as most investors know, individual share prices are kind of arbitrary, especially compared to a company's overall market cap, which gives you a better idea of how big the total company is. The number of shares that they have determines the individual share price. So, it's kind of arbitrary. I think it's really silly to calculate an index based on price. The Dow is, at this point, almost a hundred years old -- it might be over a hundred years old. And there's only 30 stocks in there, which also really doesn't give you a good representative idea of the overall market. It's just 30 big companies price-weighted. Over time, there's this multiplier that goes in there that helps them maintain consistency when they move stocks in and out of it, because they change the composition of it. It gets really convoluted. My biggest issue is the price weighting and the fact that it's only 30 companies.

Lewis: And to give some context on how that price weighting plays out, Apple is the seventh largest component of the Dow, of those 30 companies, despite the fact that it has a larger market cap than the top four weighted companies in the index combined. So, you think about the influence that it has, and really, what these indices are intended to do is be a barometer of what's going on in the stock market in terms of value, and they're also a barometer of what generally going on in the economy. When big companies do well, they tend to have an outsized impact on the economy. And I think the S&P 500 does a better job of capturing that. Also, the fact that there are 500 rather than 30 companies in the S&P 500 gives it a much better scope for what's going on in the overall economy in all these different industries.

Niu: Right. I think a market cap weight is much better approach. An interesting example to illustrate this even further is, if a Dow company has a stock split for some reason, all of the sudden they're weighted a lot less in the Dow for, again, an arbitrary reason. There's no real good reason. And companies split all the time, it's just kind of a thing that they do. So, if they do that, it could adversely impact their weighting, if they're a Dow component.

Lewis: So, being in an index is like being in a club. The people that run it need to decide that they want you in it. And for this conversation that we're going to have about index inclusion, we're going to use the S&P 500 as our example, because you and I think it's the most representative one. But, you can apply pretty much everything we're talking about to, whether it's the Russell 2000, even the Dow. Looking at the S&P 500, it's a collection that includes 500 of the largest, but not necessarily the 500 largest, companies. And I think that's a very important point to make, because there are requirements that exclude 500 of the largest U.S. companies out there.

Niu: And a quick point that I think is worth pointing out for our listeners is, the S&P 500 is very specifically the benchmark that we measure our Premium services again. That's the main benchmark that most of our services are trying to beat. It's definitely, I think, the best gauge.

Lewis: If you're looking at what it takes to be in the club, it's a look at large companies. Market cap requirement is that companies need to have a market cap above $6.1 billion. Only common stocks of U.S. companies are eligible, which means it must be a company that files a 10-K annual report. And, its listing must be on an eligible U.S. exchange. It can't be a stock on the OTC or pink sheets. Something that's going to take a little bit of unpacking to explain is, there are also requirements around organizational structure and share type. It basically has to be common stock, which will include REITs, but the index will not include any kind of more advanced structures like business development corps and master limited partnerships. Those aren't really things we talk about too much on the Tech show, but you hear a lot about them with Energy and Financials.

Niu: Right.

Lewis: And, I think one of the most important ones is profitability. For inclusion, a company needs to be gaap profitable in its most recent quarter and in sum over the past four quarters, which is something that actually winds up excluding a lot of tech companies from possibly being included in the S&P 500. There are some other requirements around trading volume and dollar value traded. But really, what we talked about there, those are the big ones. We're going to talk about one more on the back half of the show that'll get into a little bit more of a corporate governance thing. But, basically, the committee that make these decisions will look at the list throughout the year and make adjustments based on eligibility and also reweight based on market cap changes. You look at that list of requirements, I think the baseline is basically, you need to be a big company, you need to be somewhat successful, and there needs to be access for investors, both in the information you provide and in the ability to actually buy shares, there needs to be liquidity for the stock.

Niu: Right. I think that sums it up pretty nicely. It's these base requirements. You don't want these penny stocks or stocks you've never heard of or stocks that lose tons of money. It's some base rules. I think that's a good starting point as a foundation for if you're looking for stocks that are meaningful to the U.S. economy.

Lewis: Right, they shouldn't be these things that are being swung around wildly by day traders or might be circling the drain. You want it to be an accurate barometer, but at the same time, inclusion in the index is kind of a stamp of legitimacy. And they're not going to just give that out to anybody.

Niu: Right. I think there's some prestige if you're included, particularly if you're one of the smaller companies, because then it's like, "At least I'm important enough to be represented in this index."

Lewis: The latest company to join the S&P 500 Index, ship builder Huntington Ingalls. I'm going to have to check with Sarah Priestley and make sure I said that one correctly. The company was added in the beginning of 2018. That's kind of a quick rundown on the index. In the second half of the show, we're going to talk about what being in the index means for a stock, and why new issuances are going to want to be careful with how they set up their share classes.

Evan, the reason that we're talking about indices is because, frankly, there are a decent number of benefits to being an index constituent.

Niu: Right. I think the most meaningful one is that index funds are essentially required to go out and buy your stock, which technically broadens your investor base. I think there are a couple of other theoretical benefits or counterforces in terms of volatility. For example, if you have an index fund that's buying a lot of your stock, they're just buying your stock and sitting on it. They're not buying and selling your stock actively, which, on one hand, should help reduce volatility; on the other hand, the supply of shares that's being really traded in the market decreases because you have these funds that are just sitting on the shares, which can potentially amplify movements when investors are reacting, positively or negatively, to events in news. So, there are some counterforces there, but I don't think there's a huge impact on a net basis that's really too meaningful for investors. But, just some mechanics to consider. And as I mentioned before, there's a little bit of prestige of being like, "I'm part of the S&P 500."

Lewis: I think it's helpful in understanding what goes into becoming a constituent of an index, just to get an idea of who owns a stock. Twitter, because Twitter has not been gaap profitable, does not qualify to be in the S&P 500, and has been excluded.

Niu: Whereas Facebook (META -4.13%) is in.

Lewis: Exactly, Facebook has been profitable and they meet the other requirements, so they have been. I'm sure that Twitter still has plenty of institutional ownership. The difference is, Facebook has more or less required institutional ownership, because any fund that's being offered that's intended to mirror the S&P 500 needs to own Facebook in order to do that.

Niu: Right. If it's announced that a stock is joining the S&P 500 or any index, typically you'll see a little bit of a pop, which is mostly some of those institutions being like, "Might as well go start buying some of it to get ahead of it and start factoring it into the index."

Lewis: We talked before about how a lot of these things are things you want to see in a good company, the slapped sticker on there of, "You're in the index now." This is more just validating everything that was already going on there. It doesn't change anything about the business, it's more just, "You've been profitable, you've met these requirements, and you're relevant enough to the economy that we're going to include you." It's not something that's ever really core to an investment thesis, but helpful in understanding who owns these stocks and why they own them.

Niu: It's kind of a sign of validation, sort of.

Lewis: One thing I think is kind of important going forward, though, much like the laws in the United States, the requirements for these indices are not set in stone, they update with the times. And something that came up recently in 2017 was this idea that corporate governance and share classes could play a larger role in whether or not stocks are eligible for indices going forward.

Niu: Right. I think it's a really important move, because I think these index providers are increasingly starting to factor in corporate governance concerns into their methodologies. Which, really, last year, I think was done in response to Snap's (SNAP -4.04%) IPO. We talked about Snap plenty last year. They don't give their public shareholders any votes. The first one was FTSE Russell reclaiming early 2017 that public shareholders need to collectively command at least 5% of voting power, which is really a ridiculously low hurdle to clear. 5% is not a lot to ask. Right? [laughs] To give your public shareholders 5% voting power? But, public Snap investors have 0%, so they fail that test. It was a meaningful move, but it's still a very low bar to clear. Most companies are not even going to have an issue with that. So, that's what makes this seem like it was really done in response to Snap, because it's very rare for any company to give 0% voting power to public investors. It's almost unheard of. It's probably only a handful of companies that have ever tried it, Snap being the most prominent poster boy recently. 

Then, a few months after that, S&P Dow Jones followed suit. What they did was a little bit different. They said that companies with multiple share classes are not eligible for inclusion in its most prominent indexes, including the S&P 500. That's because multiple share class structures are almost universally implemented to the detriment of public shareholders, because they usually have this super voting class for insiders. Maybe they'll get 10:1 votes for insiders. That certainly undermines corporate governance. That's generally been an increasing trend. Lots of companies have been doing this multiple share class thing. Google is probably the biggest one that really started this back in the early 2000s, but then also more recently, Facebook is a good example. But, speaking of those two companies, the S&P said that existing constituents like Google or Facebook that have multiple share classes are grandfathered in, so they're not affected, they're not going to get kicked out. But going forward, they're not going to add any stocks that have multiple share classes. So, I think it's a much stronger message to companies than FTSE Russell's move, both because it's more meaningful than this 5% hurdle, but also because the S&P 500 is a lot more important than the Russell 2000 or FTSE and its indexes.

Lewis: Like most things, it can be good to get grandfathered in based on an old policy. I'm sure Alphabet and Facebook are pretty thrilled about that. What I do like about this is, it also demonstrates the market forces at play, and what might cause different company considerations. Were this not to be the case, I think you'd see a lot more companies down the road considering this type of issuance, where they're issuing non-voting shares from the get-go at their IPO, rather than doing it as a stock split type thing down the road. It will be interesting to see over the next couple of years, particularly with all these very large unicorns in the tech space probably going public at some point, what winds up happening there, and if they decide to follow Snap's lead, or if they decide it's more important to be possibly included for index inclusion down the road, and issuing, maybe, one-vote shares as their baseline shares for their IPOs.

Niu: Right. I think what we're seeing is this culmination of, I feel like over the past decade or 20 years, there's been a slow, gradual deterioration of corporate governance. The index buyers are being like, "OK, enough is enough. You guys have to stop this." It's been this very slow and subtle thing, but over time, it's quite meaningful. It's nice that organizations that can actually have an impact are starting to put their foot down and be like, "Hey, you guys need to treat your public investors better and give them more say." And the index thing itself is probably not, alone, enough to turn the tide. But I think it's a step in the right direction.

Lewis: Yeah. It's a market force. And especially when you have people that are so caught up in the idea of prestige. We talked about how this is this validating thing for a stock. To not be included might be something that would rub management, hypothetically, the wrong way. And it might get them to do some more shareholder-friendly things as they consider going public.

Niu: And Facebook is worth pointing out, too, because last year, they lost this big fight. Facebook wanted to do another share class, a third share class, with zero votes, that was just going to hurt corporate governance even further, again. And as he gives away his stock, he wanted to basically retain power. Facebook was sued, this class action lawsuit, investors were really not happy about this idea. And they finally dropped it as part of a settlement for this class action lawsuit. But it's another thing, another example of these companies that continue to expand and keep pushing deeper into this territory where they're undermining public investors and their opinions and all this stuff. That third share class was really going to be shareholder unfriendly, so it's a really good thing that they dropped it. But, that was in response to a class action lawsuit, as opposed to, for example, an index provider that we're talking about.

Lewis: So, good guy S&P coming to the rescue for the average investor. Evan, anything else before we wrap up today on the major indices or anything we talked about?

Niu: No, I think we're good.

Lewis: All right. Listeners, that does it for this episode of Industry Focus. If we sounded particularly good, give us a heads up, because like I said, this is our first time trying to shoot with this new style. We're always trying to make things sound a little bit better when we have remote folks on the horn. If you have any questions in addition to just reaching out and telling us how we sound, you can always shoot us an email at [email protected], or you can tweet us @MFIndustryFocus. If you want more of our stuff, you can subscribe on iTunes or check out The Fool's family of shows over at fool.com/podcasts. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Austin Morgan for all his work behind the glass and all his experimenting in the background to make us sound better. For Evan Niu, I'm Dylan Lewis. Thanks for listening and Fool on!