By David Sterman
In any given year, Standard & Poor's must find a dozen or so new companies to include in its vaunted S&P 500 index.
Existing components invariably get acquired, or stumble so badly that they are disinvited from this select group. Getting a tap on the shoulder from S&P is great news, simply because the billion-dollar S&P 500 index funds must immediately buy their shares to give them a proper weighting.
Analysts at Credit Suisse recently gave the topic some thought, highlighting 10 strong candidates. Later on, I'm going to add another eight of my own in a moment. And in part two of this series, I'll cite the three most appealing stocks in the group on a purely fundamental basis.
What's In The S&P 500?
Many might suspect that Standard & Poor's simply chooses companies with the largest market values for inclusion in the index. But size isn't everything. Standard & Poor's also wants to focus on industry leaders, ensuring that a wide variety of industries are well represented.
It's a crucial distinction. Simply focusing on market capitalizations might make the index too heavy on tech or banks. Companies such as U.S. Steel (X), Advanced Micro Devices (AMD) and Allegheny Technologies (ATI), for example, are all worth less than $3 billion, which is smaller than most companies in the S&P 400 mid-cap index. If market value were a primary consideration, they would have been kicked out long ago.
Still, you can't completely ignore a company's size. Here are the largest companies in the S&P 400 mid-cap index by market value.
Here are the largest mid-cap companies, in the context of sales.
These companies may seem huge, but for the most part, their profit margins are so small that they really aren't the dynamic companies that Standard & Poor's prefers for the 500-stock index. What about the mid-caps with the strongest net profits in 2012?
Notice that electronics distributors Arrow Electronics (ARW) and Avnet (AVT) appear in both tables. Indeed, this niche is quite underrepresented, as Ingram Micro (IM) and Tech Data (TECD) are similarly excluded. It is likely a matter of time before one is added to the S&P 500.
Also, industrial bearings maker Timken (TKR) and homebuilder Toll Brothers (TOL) are right behind these 10 companies in terms of 2012 profits, and it's almost inevitable that they will eventually find their way into the S&P 500 due to their industry leadership.
Now, let's look at the 10 companies that Credit Suisse believes are in consideration for inclusion in the S&P 500:
It's hard to see why Credit Suisse thinks Annaly Capital (NLY), Realty Income (O) or American Capital Agency (AGNC) merit inclusion in the S&P 500. Those companies are focused on financial engineering -- they aren't the kind of long-term wide-moat businesses that Standard & Poor's seeks out.
Yet on this list, there are four companies that look like solid bets, thanks to their industry leadership and current size: General Growth Properties (GGP), Hertz Global Holdings (HTZ), Ametek (AME) and J.B. Hunt (JBHT), which are leaders in the fields of real estate, vehicle and equipment rentals, electronic instrumentation and freight transportation, respectively.
A Duopoly Poised For Profits
In the past half-decade, Hertz and rival Avis (CAR) have bought out smaller rivals and are now global behemoths, with a combined $19 billion annual revenue base. Frankly, these were stunningly great stock picks after the 2008 financial crisis, as investors mistakenly assumed that they would hit deep financial distress.
Yet even as both of these stocks have rebounded sharply since then, the wide moats around these businesses, coupled with an eventual firming of the European economy, means they have great long-term prospects. (My colleague Dave Goodboy recently provided a savvy summary of Hertz's prospects.)
Where Are The Truckers?
The S&P 500 has always had a considerable exposure to freight transporters. Railroad operators such as CSX (CSX), Kansas City Southern (KSU), Norfolk Southern (NSC) and Union Pacific (UNP) all make the grade. But where are the trucking firms? None are the index, though J.B. Hunt, with more than $6 billion in projected 2014 sales, is the big name in the industry -- and the most likely candidate when Standard & Poor's corrects this oversight.
Tap Into The Cloud
And although the S&P 500 index has considerable exposure to technology, there are few companies solely focused on cloud computing. That's why Credit Suisse suspects that data center operator Equinix (EQIX) may soon get the nod. Over the course of your day online, you probably tap into one of Equinix's many global data centers as you surf the Web. The company's $2 billion annual revenue base may be a bit small, but this is the quintessential business model for the 21st century.
Risks to Consider: Possible inclusion in the S&P 500 should not be seen as the sole basis for an investment in these firms, especially considering that an invite may not come for another year or two.
In the next part of this series, I will be focusing on both Credit Suisse's candidates, as well as some of my own. I'll profile my top three picks that are both S&P 500 candidates and sport compelling value.