Elon Musk May Have Just Tweeted His Way Into Your Index Fund

Jul 28, 2020

Every investor has a story about the Stock That Got Away. For many people this year, that company is Tesla.

The electric vehicle maker has had a stellar 2020, with its $430 share price at the beginning of January more than tripling to its current lofty price over $1,500.

That’s despite founder Elon Musk’s, ahem, colorful presence on Twitter. Now there’s another chapter of the Tesla story being written, with the firm having just announced four quarters of profitability. What makes that noteworthy: It’s one of the key requirements for inclusion in the S&P 500.

Of course nothing is guaranteed, and the whole indexing process is as guarded as Catholic cardinals announcing a new Pope with puffs of chimney smoke. But if it does take place, that means every S&P 500 index fund out there – which collectively steer trillions of dollars in assets – is going to have start buying Tesla.

“There are three factors driving up the stock: They have shown they can ramp up production, they have demonstrated demand, and they have shown they can make money,” says Ben Kallo, senior research analyst who covers the stock for Baird. “That, along with potential S&P 500 inclusion, makes it much more real for big institutional investors.”

Supercharged returns

For investors used to a moribund auto sector that seems to flirt with bankruptcy every so often, it might seem odd to see a carmaker as one of the market’s hottest stocks.

But that’s what disruptive technology and record sales will do. Some analysts even eschew the label of a carmaker altogether, given the renewable energy portion of its business, and suggest that we need to think of it as a growth-oriented tech firm instead. Piper Sandler analyst Alexander Potter says the stock has plenty of room to move even higher, setting a price target of $2,322.

Before you start mortgaging your home to buy Tesla shares, though, take a breath and consider where valuation stands after this year’s impressive runup.

If you’re scratching your head, not to worry – even professional analysts are all over the map. That’s not unique when it comes to new technologies: It’s particularly hard to value companies when old models are being disrupted out of existence, and new ones are still taking shape.

On its face, Tesla’s current forward price-to-earnings ratio of 416 looks like it just arrived from Crazytown. Bank of America analysts called the runup “hyperbolic” and “overheated” in a recent research note, with a price target of $800.

Joining the club?

One big unknown is whether Tesla will join that highly exclusive club of the S&P 500. As one of the most valuable companies in America right now, with a market cap approaching $300 billion, it certainly seems likely at some point.

Basic requirements for index inclusion include being U.S.-based; being listed on the NYSE, Nasdaq or CBOE; having a market cap over $8.2 billion; and having racked up four quarters of profitability.

But even then, nothing is guaranteed: “Companies who meet the eligibility requirements are not automatically added to the index – they join a pool of other eligible candidates,” says S&P Dow Jones Indices spokesman Ray McConville.

Those on the index committee never tip their hand, and only make the announcement five days in advance, so as to prevent any gaming of the system. Even the company itself is kept unawares.

The bottom line for many investors: What exactly does index inclusion do to stock price?

The answer is that it does help, at least in the short-term, as index funds and others that track the benchmark rush to buy shares. When Baird’s Kallo ran the numbers for past candidates, he found that much of the benefit came prior to S&P 500 inclusion, as investors acted on anticipation. That added up to roughly 15% gains in the six months before inclusion.

Once a stock is added to the index, analysts at consulting firm McKinsey found that the boost lasted about 45 days, as tracking funds added the company to their portfolios.

For example, in 2002 when the S&P 500 lineup was tweaked, new adds like Goldman Sachs, UPS, and eBay gained about 3% over that time frame. Meanwhile those stocks that were subtracted from the index lost an average of 7.5%.

“Executives are right to believe that gaining entry or dropping out of a major index does indeed move a company’s share price,” wrote authors Marc Goedhart and Regis Huc in the paper, “What Is Stock Index Membership Worth?” “But that effect is short-lived, we found, and inclusion in a major index is not a factor in a company’s long-term valuation.”

Potential investors would be wise not to obsess about index inclusion effects, and stick to business fundamentals instead. Baird’s Kallo is a neutral on the stock right now, with a target of $1,658, not far above the closing price as of July 27.

While he’s bullish on the company and its prospects – including its energy side of the business, which he thinks could be just as transformative as its automaking side – much positivity has been baked into the stock already.

“There’s a lot of upside priced in right now, close to perfection,” Kallo says. “With the current global economy and consumers being cautious, it could impact demand – and it worries me that people aren’t talking enough about that.”

If you are an S&P 500 investor, though, it’s not like you have to come to any personal conclusions about Tesla’s valuation. If it’s added to the index, it will be coming to your portfolio – whether you like it or not.

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