Stocks tend to underperform the Nasdaq-100 Index (NDX) after joining it
The Nasdaq-100 Index (NDX) is made up of the largest 100 non-financial companies on the Nasdaq. Next Monday, they implement their national re-ranking, and will add seven new stocks to the index (and also remove seven current stocks). Before we look at which stocks are being added and removed, the analysis below shows how stocks have performed in the past after the re-rankings.
Joiners & Leavers: Going back to 2000, I found all the stocks that were added to the NDX and recorded their performance over different time frames going forward. The time frames ranged from a month to a year. Below is a summary of how those stocks performed. I show the average, median, and percent positive of those stocks' returns to give you some context.
However, those could potentially be misleading -- because while the 7.27% return over the next year seems about average, if the index had gained 15% over that time frame, then it would in fact be underperformance. That's why I'm focusing more on that last row, showing the percentage of time the stocks outperformed NDX over those time frames. You can see, in each case, the stocks added to the index underperformed it most of the time. In other words, most of the time you'd be better off buying other stocks in the index, or even simply the index itself.
One explanation for this is that once a stock is added to the index, it creates buying pressure for the stock -- especially among institutional investors who have funds that mimic the index. Also, the increased volume and buzz about the stock being added raises investor awareness and expectations. These factors cause the stock price to get inflated when added, which leads to underperformance going forward.
Next, the table below shows the stocks that left the index. You can see the returns are much better for the leavers than the joiners. A plausible theory for outperformance of leavers over joiners is simply the opposite of what causes the joiners to underperform. When a stock is removed from the index, it causes short-term selling pressure by index funds unloading the stocks, and also causes pessimism among investors who see the stocks being removed as a kind of demotion.
While I do like the theory I just proposed, as far as the table just above goes, I would be very skeptical of the numbers -- to the point that I might disregard them completely. You can see the number of returns is way lower for this table than for the prior table. That's because survivorship bias has a huge effect for stocks being removed.
Stocks that were removed due to a merger or getting bought out are not included in the leavers data. Also, stocks that went bankrupt are not included. Basically, I will be eyeing the stocks getting removed as potential buys on the basis of selling pressure and lowered expectations. I will not, however, be using the table above as evidence to support that theory.
Analyst Ranks on Joiners: Here's another look at past stocks that joined the NDX. I wanted to see if expectations for these stocks played a role in how they performed after being added to the index. Below are the six- and 12-month returns of the stocks added, depending on the percentage of analysts that had a "buy" rating on the stock, according to Zacks.
Fitting with our contrarian philosophy, the stocks that had the lowest percent "buys" -- in other words, the lowest expectations -- had a better chance at outperforming the index than stocks with a higher percentage of "buy" ratings. Still, less than half of the stocks outperformed the index one year later, even those with less than 50% analyst "buys."
Ultimately, it seems that stocks that analysts are optimistic about and are being added to the Nasdaq-100 are ones you want to avoid. Note that the number of returns is different from the table above, because I only considered stocks that had at least eight analysts rating the stock. Others were disregarded for this analysis.
Finally, below is a list of the 14 total stocks being added and removed from the NDX. I also show the number of analysts and the percentage that have a "buy" rating on the stock, according to Zacks.
Based on the analysis above, I would be wary of the stocks being added (the table on the left), especially those with a high percentage of analyst "buys." The stocks being removed (the leavers) are inclined to be under-loved -- and this could mark a good buying opportunity.
