What do the following companies have in common; Gulf Marine Services which provides support vessels for the oil industry, Brit, a specialist insurance company and Polypipe which manufactures plastic piping systems?1 They are among 29 companies joining the FTSE All Share Index today. Does this matter for equity investors?
Indices need to evolve over time to reflect the changing nature of the economy. Just like Dr Who in the eponymous BBC television programme, a process of regeneration is healthy periodically. In 1900 railroad companies2 accounted for 49% of the value of the top 100 UK companies, whilst industries like television, aerospace, pharmaceuticals and information technology did not exist. An index dominated by railway companies would not represent the investible universe today.
However the changing of the index constituents can have some important consequences. As we described in “Buffet, Index Funds and Climbing Mount Everest” index tracking funds buy the stocks in the index simply because they are there. So when an index changes they have to buy the new entrants3 and sell or reduce holdings in those stocks which are ejected or whose weightings are reduced.
Many of the current crop of new index entrants are Initial Public Offerings (IPOs) often being sold by private equity owners. The vendors can choose their timing to coincide with favourable market circumstances, which normally means relatively high valuations. We discussed one of these, Appliances Online, in “An interesting company but is it an interesting investment“. The behaviour of index funds is well understood by the IPO vendors and their advisors and is often a point of discussion during investor briefings. It is very helpful when selling a business, or even when buying one, to know that there is another big potential buyer of your company, irrespective of price. In fact, the higher the valuation of the business, the more index funds will have to buy, ceteris paribus. I am not sure how many investors realise that owning an index fund means having to buy every new issue3 or new entrant to the FTSE All Share Index.
Another consequence of index changes is that those shares which are ejected from the index or where the weighting is reduced can see considerable selling. Sometimes this coincides with shares being out of favour for other reasons and it can provide interesting investment opportunities. As described in “Finding an Edge“ Daily Mail and General Trust (DMGT) shares were heavily sold down when they were ejected from the FTSE All Share Index in June 2012 (due to their ownership / voting structure) with the market value declining to around £1.3bn at that point. This provided a great investment opportunity and the shares have almost trebled in value since (see chart).
Ironically within The DMGT Group, amongst their many assets, was a holding of 52% of Zoopla Property Group which has just completed an IPO process. The floatation price for Zoopla was set at £920m, valuing their stake at around £480m or over a third of the value of the whole of DMGT when it was ejected from the index two years ago. This valuation represents a very healthy profit on their investment in Zoopla for DMGT and their shareholders.
Furthermore if you add in the current value of DMGT’s 70% stake in Euromoney Institutional Investor of around £1bn, those two investments represent more than the total market value of DMGT in June 2012, leaving the whole newspaper group, including one of the world’s leading online news brands, a large insurance risk solutions company, and many other valuable businesses effectively valued at nothing at that point. The good news for passive investors is that their funds will once again gain some exposure to the Zoopla business assuming it moves into the index, unfortunately it will not be at such a favourable price.
1. This is no recommendation to buy or sell any particular security
2. Triumph of the optimists – Dimpson, Marsh and Staunton, 2002
3. Some Index funds operate a statistical sampling process, rather than fully replicating an index.