Buy the Nasdaq-100 Index Removals - Part I

Mark is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

While most investors celebrate the inclusion of a stock into a major index such as the Nasdaq-100, data suggests that the celebratory occasion should occur with the stocks being removed. According to research from Schaeffer’s analysts, the average stock removed since 2008 has returned 64% in the first year.                       

Considering the occasion is highlighted by forced selling from investment funds tied to the performance of the index, maybe it shouldn’t be a surprise that these kicked and beaten down stocks rebound so strongly.

Per the Nasdaq OMX Group, the following 10 stocks were removed from the index the past Monday, Dec. 24: Apollo Group (NASDAQ: APOL), Electronic Arts (NASDAQ: EA), Flextronics International, Green Mountain Coffee Roasters (NASDAQ: GMCR), Lam Research, Marvell Technology Group, Netflix (NASDAQ: NFLX), Research In Motion (NASDAQ: BBRY), VeriSign and Warner Chilcott.

Which stock will be the big winner in 2013? Or which stock won’t be a huge winner in 2013? The odds suggest few will have a weak year ahead. This initial article will focus on the general definition of the index and research while the second part will go into more analysis of the individual stocks.

Nasdaq-100 Defined

The Nasdaq-100 Index is composed of the 100 largest non-financial stocks listed on The Nasdaq Stock Market and dates to January 1985 when it was launched along with the Nasdaq Financial-100 Index, which is comprised of the 100 largest financial stocks on Nasdaq. These indexes act as benchmarks for financial products such as options, futures, and funds. The Nasdaq-100 is re-ranked each year in December, timed to coincide with the quadruple witch expiration Friday of the quarter.

The index is the basis of the PowerShares QQQ Trust, which aims to provide investment results, before expenses, corresponding to the index.

According to the Nasdaq OMX Group, the index remains the relevant investable product that is the underlying benchmark for about 7,100 products in 22 countries with a notational value of $1 trillion.

Broken Stock or Broken Companies?

Reviewing the list, the stocks can be broken down into two categories: broken stocks and broken companies. Stocks such as Electronic Arts have gone out of favor as the gaming sector has moved away from consoles and into mobile. This company still has the muscle and prominence to regain the market leadership as it pushes into mobile and social gaming. Conversely, a stock such as Research In Motion has missed out on the conversion to smart phones and faces massive competitors in Apple and Samsung that might make it impossible to regain a decent market position.

Either way, both groups could be set up for explosive gains in the next year as the stocks have been crushed over the last several years. Some stocks though might rebound for a return addition into the index while others might continue declining after an initial rebound.

Schaeffer’s Analysis

The firm provides very compelling analysis that investors should buy the stocks kicked out of the index and hold for 1 year.  The research doesn’t go beyond that point, but from 3 months to 1 year the returns are extremely bullish with positive returns on over 76% of the occurrences since 2008.

The vast difference between the average return of 64% and the median return of 43% can quickly be explained by the out-sized positive returns of Sirius XM Radio, Virgin Media and SanDisk after being kicked out of the index in 2008. Those three stocks averaged returns of nearly 280% that first year.

The returns from the stocks removed in 2011 have not been nearly as bullish suggesting part of the outsized gains is related to relative strength of the market in the previous year. As an example, 19 of 22 stocks with prior 3-month negative returns had positive outcomes. This amounts to 86% of the stocks with positive occurrences after a negative period compared to the average of 76%. In fact, stocks with a positive prior 3-month return only averaged positive gains in 50% of the scenarios.

The research suggests that investors might want to exclude the stocks of Green Mountain Coffee, Netflix, and Research In Motion that have had huge rebounds in the last 3-months.

Conclusion

The annual Nasdaq-100 removal process is yet another indication of investing requiring following the road less traveled. The typical stock being removed from the index has had at least a few bad years in order to reach a point of removal. The low investment sentiment can signal a great buying point as long as the stock remains financially strong.

Will down trodden stocks such as Apollo Group or Marvel Technology rebound from a few disastrous years? Logic suggests an investor would be crazy to buy these stocks, but history suggests the opposite. 


Mark Holder and Stone Fox Capital Advisors are long Apple. The Motley Fool owns shares of Netflix and has the following options: long DEC 2012 $16.00 puts on Green Mountain Coffee Roasters. Motley Fool newsletter services recommend Green Mountain Coffee Roasters and Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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