Introduction
companies with little or no representation within market indices have become increasingly neglected in the
current market environment. For investors seeking stocks with an attractive long-term risk/reward, this
overlooked segment of the market could offer a promising universe of potential opportunities.
Thinking Outside of the Index
Securities must meet specific criteria to garner inclusion in the key S&P 500 indices, such as being a
U.S.-domiciled company, offering adequate liquidity, and maintaining a primary listing on a U.S. exchange.
Furthermore, a number of share structures make a company ineligible for inclusion, including business
development companies and limited partnerships. In addition, companies with a tracking stock structure are
ineligible for inclusion in the main S&P indices. In July 2017, S&P Dow Jones indices announced that the S&P
Composite 1500 and its component indices (S&P 500, S&P Mid Cap 400 and S&P 600) would no longer add
companies with multiple share class structures (although existing index constituents were grandfathered in). The
S&P indices are maintained by a committee of 10 members (9 of whom are anonymous), drawn from among
S&P Dow Jones Indices employees, who attempt to include stocks that collectively represent the U.S. economy.
The committee also has the discretion to override its inclusion criteria for companies that no longer meet its
standards. For example, in 2012 the S&P decided to consider to include Aon in the S&P 500 despite its decision
to incorporate outside the U.S. Elaborating, David Blitzer, who chairs the S&P Dow Jones Indices committee,
stated that, “we will list a company that we believe, and everyone else in the investment community believes, is
a U.S. company, even though it’s incorporated outside the U.S.”
We believe that the trend of fund flows to passively managed investment vehicles has created
opportunities for active managers. With assets flowing into index funds, shares of securities are being
purchased regardless of their valuation. Meanwhile, the combination whereby asset outflows from securities is
coupled with indiscriminate investor buying has increased the valuation discrepancy between shares included in
an index and those that are not included in the index. Epoch Investment Partners recently examined the impact
of passive investing on market efficiency, citing a 2012 study by Eric Belasco, Michael Finkie and David
Nanigian entitled “The Impact of Passive Investing on Corporate Valuations,” which looked at the valuations of
stocks inside an index relative to valuations of stocks not included in the index during the period from 1993 to
2007. The study concluded that flows of funds into the S&P 500 index created a valuation discrepancy between
index and nonindex stocks on the magnitude of 1.8% on a P/E basis and 1.5% on a price/book value basis.
Accordingly, we believe that investors could benefit from looking at securities that are outside of an index as a
way to capitalize on the valuation discrepancies between a constituent and non-constituent, which has likely
increased subsequent to 2007 as a result of fund flow trends that have seen a significant amount of assets
move into passive strategies and out of active strategies.
How Do Index Orphans Become Discovered?
Supermodels are frequently asked, “How did you get discovered?” The answer seems to be that there is
no single answer; every story is different. Not to suggest that we’ve done an exhaustive study, but in posing the
question to one woman (a mere model; no “super” status involved), we were surprised to learn that “at my
uncle’s funeral” is also how it can happen.
In the same way that a person with model-caliber looks need not be concerned with getting discovered,
we believe that worrying about how index orphans will get discovered is futile. Intrinsic value has historically
acted as a magnet, drawing stock prices toward it over the long run. The conventional ways in which index
orphans have become discovered include index inclusion, new or increased sell-side coverage, and M&A. But
stock prices can also reach intrinsic value in unpredictable ways—a bucket we will refer to as “the uncle’s
funeral.”
Near the top of the list in our eclectic bucket is MoneyGram International Inc. (MGI), the #2 competitor to
Western Union (WU) in international money transfer. To call MGI a mere index orphan would be a compliment:
Before the financial crisis, its fixed income department, tasked with investing the float of its money order
business (a far smaller business within the company than money transfer), took overweight positions in
subprime mortgages and CDOs. MGI’s losses ultimately exceeded $1.5 billion, more than half of the company’s
peak market cap set in 2006. MGI required a bailout by Thomas H. Lee and Goldman Sachs, which
substantially diluted common shareholders. By late 2011, the company’s low-single-digit stock price led the
board to implement an 8:1 reverse stock split in hopes of regaining some respectability in the stock market. In
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Introduction
2014, just as MGI was getting its bearings, its largest customer, Wal-Mart, announced that it would offer a
competing domestic money transfer product (from one Wal-Mart store to another) at a large discount to MGI’s
pricing, putting substantial pressure on MGI’s revenues over the next two years. But 2017 was the year of the
uncle’s funeral, as a bidding war broke out for what had been a nearly left-for-dead stock. Ant Financial offered
to buy MGI for $13.25 per share in January (MGI shares traded at ~$6.50 in October 2016 before deal
speculation drove the stock higher), then Euronet bid $15.20 in March, and finally Ant Financial raised its bid to
$18.00 in April. Orphaned from all indices, MGI substantially outperformed all of the FAANG stocks in the past
year.
In our view, active managers will once again outperform the indices in the same way that they always
have: by owning stocks trading at large discounts to intrinsic value and being patient. Given the unprecedented
inflows into index funds, we believe that one of the best hunting grounds for such large discounts to intrinsic
value is likely to be in index orphans.
Updates on Index Orphans in the Existing AAF Universe
In this section, we provide updates on a few securities that have been previously profiled in
AAF
and
that are not in one of the major S&P indices:
Conduent Incorporated (ticker: CNDT, $16.30)
The newly independent Conduent was spun off from Xerox in January. Conduent is in the business
process outsourcing (BPO) industry. CNDT’s services and capabilities include customer care, human resources,
payments, transaction processing, and transportation services. We believe CNDT has multiple catalysts for
value creation during the coming years, and its exclusion from market indices has caused this opportunity to be
underappreciated by investors. Moreover, CNDT possesses many of the traits that have allowed spin-offs to
outperform historically. In addition to significant cost reduction potential ($700 million), there should be
meaningful potential to enhance margins by addressing underperforming businesses and boosting investment in
higher-return areas. In addition, CNDT has meaningful growth opportunities. Its ~$6 billion in annual revenue is
modest relative to its addressable market, which is roughly $260 billion, and its addressable market has been
growing at approximately 6% per year. Our estimate of intrinsic value for CNDT is approximately $23 per share.
This estimate assumes an EV/EBITDA multiple of 8.0x and a P/E ratio of 14.0x applied to our 2019 financial
projections. In our view, this estimate of intrinsic value could prove to be conservative from a long-term
perspective, and it is conceivable that CNDT could become an acquisition candidate at some point.
Liberty Global plc (ticker: LBTYA/LBTYB/LBTYK, $30.82)
Liberty Global (LGI), chaired by cable tycoon John Malone (3% economic, 25% voting stake), is the
leading cable systems operator in Europe, with 26 million customers. LGI is a prototypical index orphan. LGI is
co-domiciled in the US and the UK, generates substantially all of its revenue in the UK and EU, but is listed on
the NASDAQ. LGI has three share classes and is also a tracking stock, with a separate currency tracking the
value of its Latin American and Carribean assets (LiLAC Group, ticker LILA/LILAB/LILAK). Unsurprisingly then,
LGI is not included in the major indexes in the US or Europe, and its passive ownership stands at just ~7%. LGI
shares have declined 53% from their mid-2015 highs, reflecting deflated expectations of a buyout (Vodafone
remains a potential long-term acquirer), currency headwinds, and execution stumbles at Virgin UK’s Project
Lightning expansion operation. Yet the company remains uniquely well positioned to capitalize on secular
growth in broadband consumption and quadruple-play integration in the coming years. At 9.5x EBITDA, we
estimate LGI’s intrinsic value could reach $48/share in 2 years.
QVC Group (ticker: QVCA, $22.24)
We have long believed that QVC Group’s status as a tracking stock has prevented it from attaining a
multiple reflective of its strong underlying fundamentals including outisized profitability (+20% EBITDA margins)
and robust free cash flow generation. As we noted earlier in our introduction, tracking stocks are precluded from
indices maintained by Standard & Poor’s. However, QVC Group is scheduled to become its own asset-backed
company following the separation of its sister tracker Liberty Ventures during the first quarter of 2018. In our
view, the pending separation could pave the way for meaningful multiple expansion at this premier online retailer
that currently trades at an attractive valuation and offers multiple avenues for future growth. Our estimate of the
Company’s intrinsic value is $32 a share (pre HSN combination), representing ~44% upside from current levels.
There are a number of factors that could drive meaningful upside to this projection including the realization of
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