Are Index Rejects Smart Buys?


Joining a prestigious stock index is a mark of a major achievement for most companies. For investors, though, you may be better off looking at the stocks that got removed from the index rather than the up-and-coming stocks that replaced them.

Late last month, the annual re-ranking for the Nasdaq 100 Index occurred, leading to 10 new companies getting added to the index. Yet some of the stocks that lost their place in the index have had extremely strong upward moves after the index changes, raising the question of whether index additions are a positive indicator or a contrary one.

The big movers
The Nasdaq 100 includes the 100 top non-financial stocks that are listed on the Nasdaq stock exchange. Every year, the index re-ranks Nasdaq stocks, making changes as necessary to reflect the ups and downs of the various components. So when stocks in the index do poorly, they run the risk of getting dropped in favor of high-performing stocks that just barely missed the list the previous year.

The index is a big deal, because substantial amounts of money track the Nasdaq 100. Most important, the PowerShares QQQ ETF follows the index, and as one of the market's biggest ETFs with more than $32 billion under management, big changes to the index can result in massive short-term buying and selling pressure. And from a long-term investment perspective, joining the Nasdaq 100 can help a company gain new attention from investors who might not have been familiar with the stock previously.

As a result, some of the new picks have done pretty well. Western Digital is up 14% since the late-December rebalancing, as the prospects for enterprise-level hard drives have grown in light of the ongoing move toward cloud computing and big-data storage solutions. Catamaran has continued its long upward trend, rising almost 8% as the pharmacy benefit manager rises in status in the industry.

But several companies that got left out of the Nasdaq 100 have had the best performance. Netflix has soared more than 75% as the company has made important content-streaming deals and had an extremely positive earnings report last week, showing continued subscriber growth and success in its international expansion. Research In Motion has soared almost 50% since late December, as hopes rise that the company's BlackBerry 10 could prove to be a game changer for the company.

Not as uncommon as you'd think
Those results may seem counterintuitive, but as it turns out, they've happened before. Schaeffer's Investment Research took a longer-term look at stocks that were deleted from the Nasdaq 100 index and found that those stocks averaged a return of more than 63% in the year following their being kicked out.

On one hand, rebounds among beaten-down stocks make some sense. After all, value-investing principles predict that after suffering a big enough decline to get booted out of the Nasdaq 100, a stock should be primed to recover, since its valuation suddenly looks more attractive.

On the other hand, though, it's curious why these particular high-flying index-reject stocks chose now to have big rebounds. Investors have known for months that RIM would have its new BlackBerry coming out, yet many wrote it off as an unlikely catalyst for a doomed stock. For Netflix, even the positive results that the company reported didn't seem like a big enough deal to justify a two-day advance of more than 60%.

Watch for value
Generalizing about the wisdom of buying stocks that get removed from the Nasdaq 100 or other indexes is apt to get you in trouble, as each individual stock story is different. Trying to separate smart value buys from value traps is a tricky business, but successful investors have used that strategy well to improve their odds. They aren't sure things, but looking at companies that lost their Nasdaq 100 status as a starting point for further research could well turn out to be a smart move.

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Fool contributor Dan Caplinger has no position in any stocks mentioned. You can follow him on Twitter @DanCaplinger. The Motley Fool recommends Catamaran and Netflix. The Motley Fool owns shares of Catamaran, Netflix, and Western Digital. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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