By Steven Ralston, CFA
Standard & Poor's announced on Monday that DeVry Inc. (DV) will replace General Motors (GM) in the S&P 500 stock index after the close today. Obviously, the bankruptcy filing motivated the Committee to remove GM from the index, but the decision to add DeVry has many implications.
First, the S&P 500 index is owned and maintained by Standard & Poor's, which is a division of McGraw-Hill (MHP). A Committee selects new companies for inclusion in the S&P 500 when there is a vacancy. The Committee seeks stocks that will provide fair representation of the many diverse industries in the U.S economy. The stocks should also meet the criteria of being large capitalization and having sufficient liquidity.
The addition of DeVry should not come as a surprise. The stock was in the S&P MidCap 400, a fertile ground from which the Committee chooses new additions to the large-cap S&P 500 stock index. DeVry's stock has a market capitalization over $3 billion and has performed well since entering the S&P MidCap 400 index, rising from a mid-capitalization to large-capitalization stock.
The first immediate impact is a rally in the stock's price, as portfolio managers that attempt to minimize their portfolio's tracking error versus the S&P 500 stock index usually buy the shares of companies that are entering the index, which explains the 4%+ rise in DeVry shares yesterday, commonly referred to as "the index effect."
According to the Standard & Poor's study in 2004, the median excess returns between announcement date and effective date of addition for those stocks added to the S&P 500 between mid-2002 and mid-2004 was 3.6%.
However, according to a study entitled "The long-term price effect of S&P 500 index addition and earnings quality," a stock's addition to the S&P 500 motivates management to increase its focus on financial performance and to increase the level of quality financial disclosure, which ultimately lead to better future returns.
Though Standard & Poor's Committee rejects the notion that investment merits influence its stock selection procedure, studies by Jain (1987), Denis et al. (2003), and Platikanova (2008) indicate that DeVry's future is bright, since excess returns should be expected.
We continue to rate DeVry's stock a Buy. Management continues to execute well with the company reporting positive enrollment trends since its turnaround in fiscal 2006.
In addition, management is executing a five year strategic plan that focuses on four priorities in order to drive growth while maintaining the company's financial strength. Finally, the ongoing real estate optimization strategy and incremental acquisitions are adding to the company's earnings potential.