On July 15th Tesla Motors (TSLA) replaced ORCL as a member of the NASDAQ-100 index (NDX). This made the stock eligible for inclusion in ETFs such as such as the PowerShares QQQ (QQQ) and the First Trust NASDAQ-100 Equal Weighted Index Fund (QQEW). Price action in the stock was as expected, with shares hitting an all time intraday high of over $133 on July 15th, and subsequently settling back into the $120 range the following days. While the addition to the NASDAQ-100 has certainly been a positive validation for the company and the stock, here I would like to discuss another event that could very well become relevant for TSLA in the not too distant future: The inclusion of TSLA in the Standard & Poor's 500 index (^GSPC).
The S&P 500 is a stock market index based on the market capitalizations of 500 leading companies publicly traded in the U.S. As companies in the index get acquired or have their market cap drop below a certain threshold they are removed from the index and replaced by others at the discretion of the S&P Index Committee, a team of Standard & Poor's economists and index analysts, who meet on a regular basis. Companies may not apply for inclusion but instead the Index Committee examines five main criteria when looking for Index candidates: trading analysis and liquidity, ownership, fundamental analysis, market capitalization, and sector representation. Next I will look at each of these five criteria and analyze how TSLA fits them.
The first criterion the stock needs to fit is that it trades with sufficient liquidity. One of the specific liquidity measures that Standard and Poor's uses is average monthly share volume divided by shares outstanding. For a NASDAQ traded stock like TSLA this number should be 0.6. In addition, the stock's price history is analyzed in order to minimize the single-digit priced stocks in the Index. Finally, it is also regarded as a good sign of liquidity if options trade on the stock. In the case of TSLA the three month volume average currently stands at over 11 million shares traded daily. If we assume 20 trading days per month, the monthly average comes to 220 million shares traded. With 115 million shares currently outstanding, the number we get for TSLA is 1.91, which is significantly over the 0.6 cutoff. Since TSLA has not traded in the single digits since the IPO in 2010, and is currently trading well over $100 per share, there is also a solid price history for the stock. Finally there are also a large number of options traded for the stock (going out to Jan 2015).
The second criterion a stock considered for inclusion in the S&P 500 needs to fulfill, is that the float is of sufficient size to allow investors to replicate the index. Specifically, this means that the stock needs to fulfill two conditions: 1) no single entity may hold more than 50% of the outstanding shares, and 2) multiple entities (excluding mutual funds) may not hold more than 60% of the outstanding shares. Founder Elon Musk is the single biggest shareholder of TSLA with a little over 28 million shares as of May 30th. This corresponds to almost 25% of outstanding shares, but still well below the 50% maximum in regards to the S&P 500 criterion. Other insiders bring the total insider ownership of the stock to a total of 38% shares outstanding. Institutional ownership, however is a different story. In the case of TSLA, around 68% of outstanding shares are held by institutions and mutual funds, but excluding insiders. Once we add the shares held by insiders we arrive at a number larger than 100%. This is possible due to the large short interest in the stock (number of shares sold short), although the number of shares sold short has come down significantly in recent months. Therefore TSLA would probably fall outside of the 60% ownership cutoff number.
The third criterion for inclusion in the S&P 500 is fundamental analysis. Specifically this means that a company considered needs to have four quarters of positive net income on an operating basis. Clearly this is not (yet) the case for Tesla Motors, as the last quarter was the company's first profitable quarter, and Elon Musk said during the last shareholder meeting that the next quarter (Q2) would not be profitable due to Model S deliveries to Europe. If we assume that the three quarter after that will be profitable, the end of the first quarter in 2014 would be the first time Tesla Motors would pass the four quarters of profitability hurdle.
The fourth criterion S&P considers is market capitalization. As a rule of thumb, the market cap range for the S&P MidCap 400 is from $1 billion to around $5 billion. The market cap for inclusion in the S&P 500 is generally over $4 billion. Therefore TSLA with a current market cap of almost $15 billion (barring a major drop in share price) would certainly be considered for the S&P 500 and not the MidCap 400.
The fifth and final criterion for inclusion in the S&P 500 is probably also the most amorphous one: sector representation. The Index Committee tries to keep the weight of each sector in each Index in line with the sector weightings of the universe. In this case, the respective universe is the all the stocks in the Standard & Poor's Stock Guide Database, (with the exception of real-estate investment trusts (REITs), closed-end funds, and American Depository Receipts (ADRs)), which fall within the market capitalization ranges of each specific Index. As a result of mergers, spin-offs, market cap changes etc, the Index will from time to time become over- or underweighted versus their specific stock universe. While the committee rarely removes a company to correct an overweight condition, it does have a preference for adding new companies to each Index from a sector that will correct an underweight condition. The ten sectors in the S&P 500 are: Consumer Discretionary, Consumer Staples, Energy, Financials, Health Care, Industrials, Information Technology, Materials, Telecommunications Services, Utilities. Automobile manufacturers fall in the Consumer Discretionary sector, and have their own sub-industry group. Of the American automakers, currently only Ford (F) and General Motors (GM), which has on June 6th 2013 been added back to the Index, are members of the S&P 500. As a commenter to my last article correctly pointed out, Chrysler, although by many considered the third American automaker is actually majority-owned (58.5%) by Italian automaker Fiat (OTCPK:FIATY) and therefore doesn't fit S&P's criterion that companies should not be headquartered in foreign countries. According to recent reports , Fiat might actually try to buy the rest of Chrysler from the United Auto Workers' health-care trust (which owns the remaining 41.5%) before an IPO requested by the UAW can take place. This means that out of the 500 companies in the S&P 500 only two are car manufacturers. Ford with a market cap of around $66 billion and GM with a market cap of around $50 billion make up only about 1% of the S&P 500's total market cap of over $10 Trillion. If we look at the representation of other international carmakers in their respective benchmark indices, we can see that the German DAX 30 (^GDAXI) counts all three German car manufacturers BMW (OTCPK:BAMXF), Daimler (OTCPK:DDAIF) and VW (OTCQX:VLKAY) among its 30 components. The Japanese Nikkei 225 is also weighted significantly towards automakers, with Honda (HMC), Mazda (OTCPK:MZDAF), Mitsubishi (OTCPK:MMTOF), Nissan (OTCPK:NSANY), Suzuki (OTCPK:SZKMY) and Toyota (TM) all among its components. It is thus quite likely that over-representation of carmakers is not going to be a reason to keep TESLA out of the S&P 500.
After looking at all five inclusion criteria it is clear that TSLA passes on three, will in all likelihood fulfill the fourth one in early 2014, and would not pass the ownership criterion. If we assume that Elon Musk is holding on to most of his shares, and institutions aren't selling large chunks of their holdings, only an even more significant drop in short interest or a sizeable secondary offering would increase the float to an acceptable level. Personally I think neither one of these two scenarios is likely to unfold anytime soon. At first glance this would seem to indicate that the chances that TSLA will be included in the S&P 500 anytime soon are actually very slim. However we also have to take into account that the guidelines for inclusion are only guidelines. According to the General Criteria for S&P U.S. Index Membership: "a company meeting all of these criteria is not assured of being added to an S&P Index. Likewise, the fact that a company might not meet all of the above requirements does not mean that it cannot be added to an Index. Candidates are reviewed regularly, and eligible candidates are placed in a replacement pool. Upon an Index opening, an appropriate candidate is selected for Index inclusion. Remember, these are only guidelines and not rules, and on occasion Standard & Poor's may go outside these guidelines in choosing Index candidates."
If we therefore assume that the index committee decides to include TSLA in the S&P 500 despite the low available float, we next have to consider the potential price action in the stock.
Standard and Poor's usually announces the inclusion of a new stock in the S&P 500 only a few days before this action will take place. This often has the respective stock booking significant gains in the afterhours session, since it is known that, after addition to the index, a large number of Mutual Funds and ETFs replicating the index are required to purchase the stock. All of the 7 stocks added to the index to date for 2013 either hit 52 week highs or had significant gains on the day after the announcement or the day of the addition to the index. While the percentage gains usually aren't huge, the increase in volume of shares traded on the day of the inclusion is significant (see table).
3 month avg vol [Millions]
Vol on d* [Millions]
d* = day of inclusion into S&P 500
This could become especially relevant in the case of TSLA where the available float is expected to be smaller than the average stock's (even if the free float increases by the time TSLA is added to the index). If there are still a large number of shares sold short at that time, an investor short TSLA might consider covering well beforehand and re-opening their position towards the end of the day of the inclusion in the index. Since the addition to the S&P 500 would not have any material impact on the business of Tesla Motors (or most other stocks added to the index) it is not surprising that most stocks added to the S&P 500 underperform the broader market several days after their inclusion. The following table shows that five of seven stocks added to the S&P 500 this year underperformed the index several days after their inclusion.
Price on d*
% difference d* to +10d
Change in S&P 500 d* to +10d
d* = day of inclusion into S&P 500
+10d = 10 days after inclusion into S&P 500
The big outlier, Regeneron Pharmaceuticals (REGN), gained significantly afterwards because of a significant Q1 earnings beat and guidance hike. Barring a similar performance by TSLA (always a possibility around earnings announcement), I would anticipate the stock to give back most of the gains achieved shortly prior and during the day of the inclusion (as was the case after the addition to the NASDAQ-100).
In case TSLA will be added to the S&P 500 despite a small available free float, the sizeable number of shares being purchased by Mutual Funds and ETFs replicating the index is expected to result in a significant but temporary rise in share price that could provide investors with lucrative long and short possibilities.