“The truth is that a year after they listed and started trading, these three companies will still be money-losing businesses, with business models still in progress and corporate governance horror stories,” Damodaran wrote in his blog post, noting that S&P needs time to manage the transition to an index of three trillion-dollar companies, even though the three companies are not challenged to challenge. Largest market cap stocks in the market.
Within a week of the SpaceX IPO, S&P Dow Jones Indices moved to reduce near-term uncertainty by confirming that it would retain the rule requiring at least one year of trading before a company qualifies for the S&P 500. It effectively pushes the decision to include SpaceX, OpenAI or the Anthropic 2020 list this year as the most likely to be included in 2020.
Also read | Shares of SpaceX fell for the first time since its blockbuster debut
Arguing that not including SpaceX, OpenAI, and Anthropic in the index will reduce market momentum somewhat, he said their price paths will be determined by how the AI story continues, both in terms of substance (growth, unit economics, reinvestment) and perception (hype and momentum).
“What is valuable is that S&P requires more of these companies in its index than it needs, as a result companies will not go out of their way to meet index requirements that they feel are too expensive for them, and if there is a turn, it will be S&P that will do it,” the ‘valuation guru’ wrote in the blog.
The S&P 500, it reminds investors, is constructed as a free-float, market-cap weighted index of the 500 largest US-listed companies, screened for listing age, liquidity and profitability. Bringing in multiple trillion-dollar, money-losing, governance-controversial companies won’t move the index’s level on the first day — the divisor is adjusted to neutralize the mechanical effect — but it will change the index’s fundamentals: “more risk, a near-term hit to earnings and perhaps a long-term increase in growth.”
Also read | SpaceX IPO: Good Business, Wrong Price? Why Aswath Damodaran is leaving Musk’s mega offer
Windfall validation of index inclusion
One of Damodaran’s central warnings is directed at investors who believe that inclusion in the S&P 500 guarantees continued gains in stocks or that exclusion is always a permanent negative. He reviewed empirical work on the index effect, focusing on Standard & Poor’s study of 715 additions and 711 deletions between 1995 and 2021, which found that while there are still short-term price increases for inclusions and decreases for deletions, the magnitude of both effects is now largely stable.
“Over the past decade or two,” he summarizes, “the bump in stock prices from index inclusion has largely disappeared,” even as the proportion of assets in index funds has increased. He adds that companies added to the S&P 500 are now more likely to underperform than outperform in the 12 months following entry. As a high-profile example, he cited Tesla’s December 2020 inclusion in the index, noting that not only did the stock subsequently underperform the S&P 500 but that Apartment Investment & Management, the smaller REIT it replaced, “significantly underperformed.”
For portfolio owners, the message is clear: trading around index actions is a thin-edge strategy, and the real impact of adding SpaceX or OpenAI to a benchmark will be on the total earnings, growth and risk profile of the index, not on the guaranteed “index premium” in those stocks.
He is skeptical of the claim that a reduction in active management automatically reduces market efficiency. Most active managers, he says, do not uncover deep mispricings but are “built around a belief in publicly available information and the power of mean reversion.” A subset of realistically information-generating investors is too small and resilient, in his view, to coexist with a larger passive ecosystem.
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