October 12, 2017
Volume XLIII, Issue VII & VIII
Introduction: Index Orphans
“ETFs as a concept and passive investing as a concept by their very nature make the
market less efficient. Efficient market theory says that millions of people doing research
following every movement of every company is how they come close to predicting earnings. If
you are buying an ETF or passive investment in an index, you are not doing that kind of
research. ETFs and passive investments by their very nature are beginning to build inefficiency
in the market and that I don’t believe will be resolved happily.”
– Art Cashin, UBS
As our longtime readers are aware, we typically devote the pages of this publication, which we
previously referred to as our Summer Issue (we now refer to this publication as our Thematic Piece due to our
new publication schedule), to an out-of-favor industry or other timely topic. Over the years, a number of our
profiles of out-of-favor industries have proven particularly opportune, including our examinations of housing in
2011, retailers with large real estate ownership in 2004 (4 of the 5 profiled retailers were subsequently
acquired), and cable/satellite distribution and entertainment in 2002. Meanwhile, timely topics have included, but
certainly have not been limited to, profiting from uncertainty (2016), conglomerates (2014), bond-like equities
(2010), spin-offs (2007), and companies with supervoting share class structures (2005).
Although all of the major market averages are currently at or near all-time highs, it is not that hard to
identify an out-of-favor industry in today’s bifurcated market, which is being led upward by the so-called FAANG
stocks (Facebook, Apple, Amazon, Netflix, Google/Alphabet). Through the first 9 months of 2017, stocks that
constitute the S&P 500 Information Technology sector were up 27.4%, compared with a gain of 14.2% for the
S&P 500 as a whole. At the other end of the spectrum, a number of sectors and industry groups are facing
challenges. Notably, two S&P 500 GICS sectors have posted negative returns for the first three quarters of the
year: energy (-6.6%) and telecom services (-4.7%). Meanwhile, a number of industry groups within the S&P 500
are down significantly from their recent highs even as the GICS sectors in which they are categorized have
posted positive performance. Over the past year (through 9/30/2017), approximately 55% of the S&P 500’s ~60
industry groups underperformed the S&P 500, which posted a 17.9% return over that time frame. A few of the
out-of-favor, if not controversial, industries in today’s market include multiline retail (down ~18% from recent 52-
week highs) and broadcast and cable/TV (down 17%). Given the disruption taking place in these
aforementioned industry groups (cable networks from OTT distribution, retail from Amazon), it’s not an easy task
determining whether the current headwinds facing these industries are temporary or secular.
Accordingly, we approached the task of coming up with a topic for this year’s issue in a slightly different
manner. Rather than seek out an out-of-favor industry or timely topic, we thought it would be value added to
identify a way for active managers to benefit from one of the key trends that has been going against them for
several years: the flow of assets from active strategies to passively managed vehicles. Our curiosity led us to
examine U.S. publicly traded securities that are not included in key S&P indices (S&P 500, S&P Mid Cap 400,
S&P Small Cap 600) and that have a low ownership in passive products such as index funds and ETFs. In our
view, these so-called “index orphans” have likely been left behind, in part, by a combination of strong inflows
into passive products and outflows from active managers.
During 2016, inflows into passively managed products (index funds and ETFs) totaled $426 billion in the
U.S., while actively managed funds experienced outflows totaling $326 billion, according to fund industry
researcher Morningstar. Although these fund flow trends have been occurring for a number of years, the
magnitude of the spread between active and passive investing in 2016 was the greatest on record.
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Introduction
Active and Passive Fund Flows Diverging Materially
Source: Morningstar Direct. Date as of 31/12/2016.
Fund flows into index funds and passively managed ETFs generate demand for securities included in
their respective indices, boosting valuations and performance—which attracts more fund flows and more buying,
creating a self-fulfilling prophecy. Meanwhile, outflows from active managers have contributed to the
underperformance of active managers as a whole due to the forced selling of stocks that other active managers
may also hold. In a later section, we highlight the valuation discrepancy between index and nonindex stocks,
reinforcing our view of the performance challenges created by adverse fund flows.
Approximately 750 publicly traded equity securities have market caps greater than $1 billion and are
also not included in one of the three aforementioned indices, with nearly 60 names boasting market
capitalizations in excess of $10 billion (the entire list will be made available to subscribers in a separate mailing).
In identifying names for this year’s issue, we focused on those with passive ownership of less than 18%, a figure
that is below the ~22% passive ownership average for stocks included in the S&P 500. It’s not surprising that
AAF
has profiled 29 of these nonconstituents in recent years, given our philosophy of finding underfollowed and
underappreciated businesses. With flows into passively managed products looking like they will continue
unabated for the foreseeable future, it’s prudent to ask how these index orphan securities will ultimately be fairly
recognized by the market. In our view, there are multiple ways that these securities’ underlying values will be
recognized, and we detail these factors later in the report. However, it is worth reminding readers of one of our
long-held beliefs: if the public markets do not recognize the disconnect between a company’s share price and its
intrinsic value, then someone else (an acquirer) will. This is why a large percentage of all the securities featured
in
AAF
since its inception in 1975 have been acquired after being profiled.
We do not have to remind our readers that when the mainstream media starts to proclaim the end of
something (the death of equities, etc.) the sentiment in question is probably at or close to its peak. With many
market pundits claiming the death of active management, we believe that investors looking beyond market
indices and focusing on individual security selection will be rewarded when investor sentiment changes and
active management begins to outperform. While we may be less certain about the recovery/turnaround potential
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