Profit by Buying the S&P 500's Castoffs

There has been upside to buying stocks booted out of the large-cap indexes. Investment advisory firm Research Affiliates LLC found that stocks dumped by the S&P 500 index have gone on to outperform the large-cap index by more than 5% per year. The firm’s analysis covered the period of 1990 to 2022. (Stocks nixed from the indexes because of mergers or acquisitions were excluded from the analysis.)

Valuations and liquidity are the reason. Prior to being cast off from the S&P 500, the Nasdaq-100 index or the Russell 1000 index, such stocks underperform. They tend to further underperform as portfolio managers tracking the respective index sell their shares. This downward pressure results in low relative valuations.

This valuation gap starts closing after post-deletion selling has subsided. Then these stocks begin to feel love from investors again and go on to outperform.

Sounds simple, doesn’t it? Identify the stocks that have been removed from the S&P 500, Nasdaq-100 or Russell 1000—information that is accessible through press releases—buy them and hold them for five years. Well, there are caveats to consider.

The study’s coauthors Rob Arnott and Forrest Henslee acknowledged that deletions haven’t beaten the S&P 500, Nasdaq-100 or Russell 1000 over the last decade. “The current growth-dominated bull market has left value and small-cap stocks in the dust.”

Buying and holding deletions is a value strategy with a significant small-cap tilt. It involves buying stocks that are now undervalued because they were booted out of large-cap indexes. When value and size underperform, so does the deletions strategy. (Size plays a role because stocks that are nixed from the Russell 1000 are too small for the S&P 500 or the Nasdaq-100.)

The deletions strategy has beaten the Russell 2000 Value index over the past 33 years. “When deletions outpace the Russell 2000 Value, they win by more than 18%, on average … When deletions underperform, they lag by 5.3% on average, with a shortfall of over 10% only twice,” observed Arnott and Henslee.

Those seeking to incorporate this strategy should note that a quality requirement is included in the newly launched Research Affiliates Deletions index (NIXT). It considers debt metrics, a company’s total payout ratio (five years of retained earnings to five years of gross profits) and net payout ratio (dividends and buybacks relative to total assets). Companies ranking in the bottom 20% are excluded. This was not mentioned in the deletions paper. A+ Investor, VMQ Stocks and Platinum subscribers could use the A+ Quality Grade as a substitute to weed out the stocks with the weakest quality.

No exchange-traded fund (ETF) currently exists to track this strategy. The index rules call for an equal weighting, with the portfolio rebalanced once per year. Stocks are held for a maximum of five years.

It makes sense that the booted companies would become undervalued and bounce back. It also makes sense to overlay a quality filter because some companies are booted from the indexes because they are no longer good companies. But, as stated above, this is a value strategy. It is likely to do well when value stocks—particularly small-cap value stocks—do well and lag when they don’t.