When Will Netflix Join the S&P 500?

"Passive investing" may sound dull and listless. But even the index funds on which passive investing depends aren't completely static. The stocks that compose them can change at any time -- and with trillions of dollars indexed in these funds, changes in their holdings can be a big deal for investors.

Ground rules
The S&P 500 is probably the best-known index after the Dow Jones Industrial Average. Its little sibling, the mid-cap-oriented S&P 400, could contain candidates poised to move up into the "big leagues," kicking out S&P 500 stalwarts in the process. According to the S&P itself, its overall considerations for membership in various indexes include:

• Liquidity: The company needs to have enough shares traded to allow investors to trade the stock without undue complications.
• Share price: The S&P aims to minimize the number of stocks with single-digit share prices.
• Float: One or more entities can't own too large a percentage of the outstanding shares.
• Profitability: Generally, the S&P wants at least four consecutive quarters of positive net income.
• Size: There are many exceptions, but while the S&P 500 mainly contains companies with market caps of $4 billion or more, the S&P 400 aims for a market-cap range of between $1 billion and $5 billion.
• Sector: The indexes aim to keep their sector allocations in line with those of the overall market.

In addition, for the S&P 500, "The guiding principle for inclusion in the S&P 500 is leading companies in leading US industries."

On the cusp
So which companies are likely candidates for shuffling? Let's look at the five smallest companies in the S&P 500, and the five biggest in the S&P 400:

S&P 500

Source: Standard & Poor's.

S&P 400

Source: Standard & Poor's. As of Oct. 29.

As you can see, the top "mid-caps" are five to eight times bigger than the S&P 500 components!

So which companies will get ejected from the S&P 500? It's easy to spot companies that might get the boot, but it's hard to know which ones will, and when. Remember that there's no fixed formula used -- just the discretion of the selection committee. That said, Eastman Kodak, New York Times, and Office Depot all sport single-digit share prices, which the S&P is trying to minimize. All have been posting losses and shrinking revenue over the past few years.

AK Steel, in contrast, has strong prospects once our economic recovery gains traction. It's an efficient producer with healthy growth projections.

Which promising companies are most likely to move up? Well, Netflix has been growing like gangbusters, first by renting DVDs through the mail, and now through the swift expansion of its less costly streaming delivery system. New York Community Bancorp has been averaging revenue growth over around 10% over the past few years, and is posting gains in EPS as it ramps up its loan portfolio. Vertex Pharmaceuticals boasts a promising hepatitis C treatment, telaprevir, but it's not yet a proven profit generator. Again, it's hard to say which companies are most likely to move up.

Not what you might expect
But wait -- there's even more uncertainty! You might think that if Office Depot is ousted from the S&P 500, it will be replaced by another retailer, but the index doesn't always work that way. In August, multinational conglomerate Tyco International joined the S&P 500, replacing oilfield specialist Smith International, which was acquired by oil giant Schlumberger. In July, insurer ACE Limited replaced health-care company Millipore, which Merck KGaA purchased.

It's clearly difficult to estimate which companies will do the S&P shuffle -- but is it still worth the effort? I say no. Many investors like to play the game because any company that joins the index will likely enjoy a healthy boost to its share price. But the best way to find great performers for your portfolio is to focus on how well they run their operations, and how much potential they have. Leave the guesswork to less disciplined investors.

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