Thanks for sharing these links. It’s always worth reading the literature and I agree there is no way of knowing for certain how S&P 500 addition will impact the stock price, but it is possible to form a much more Tesla specific view than these generic studies. There are a number of omissions in all these studies and also reasons why these are not directly applicable to the situation at Tesla
Here I’d first recommend reading my recent post about what share prices actually are and how they work price because it will make it easier to understand the following explanation for the impact of S&P 500 addition to Tesla share price.
So back to S&P 500 membership
The main problems with these studies on share price impact of S&P 500 addition are:
- These studies are on share price changes after the official S&P announcement and during later months and so misses share price changes driven by anticipation of the announcement. So these studies do not take account of the fact that many investors will anticipate S&P addition (particularly if it is driven by meeting the profit criteria) and this will have increased their valuations or gut feel conviction (or brought in new short term traders betting on a S&P bump). So share price will be boosted ahead of an S&P addition, not only after the official announcement and it is not only driven directly by passive fund buying.
- There is a huge difference between companies being promoted from the S&P400 to the S&P 500 vs companies going straight into the S&P 500 index and this is not accounted for in these studies. S&P 400 is broadly the 500-900 largest profitable US companies with liquid equity. Many passive funds already own S&P 400 companies and transition to S&P 400 to 500 is mostly just transferring shares between funds so you shouldn't expect a large share price change. These are by far the most common transitions and they are most often due to meeting market cap thresholds or S&P500 exits due to M&A (and I think for these S&P500 addition is relatively hard to predict in advance). However, If a company moves straight into the S&P500 from outside the S&P universe (most likely because it has now met the S&P profitability criteria), this forces far higher incremental buying from passive funds and a far higher change in the share price. This study shows the importance of prior S&P400 membership but the study still has many shortcomings - http://janschnitzler.com/wp-content/uploads/2016/12/sp500.pdf
- Nearly all of these S&P 500 studies use pre-crisis data which is over 10 years old. This is a very significant flaw given close to doubling of the % of US stocks held by passive investing and index tracking funds during these 10-12 years. This clearly increases share price leverage to index additions. This is partially offset by increased market liquidity due to reduced transaction costs the past 10 years.
- The more difficult a company is to value and the more divergent the investment narratives, then the larger distribution of share price valuations (whether explicit or sub-consciousness gut-feel) within the current investor base. This makes a stock price much more sensitive to changes in supply and demand of shares. If 90% of investors have a valuation within +-10% of the current share price, then changes in shares available to active investors will not cause a dramatic change in share price. However if only 5% investors have a valuation within +-10% of the current share price, it is very easy for changes in availability of shares (in this case due to shares locked up by passive investors) to cause significant changes in the share price.
So all of these factors point to S&P 500 membership being far more significant to Tesla share price than the market averages measured by these studies: 1) Passive Investors now own a far higher % of US market caps, 2) Tesla will be promoted from outside the current S&P index universe, 3) Tesla is very hard to value and investors have a very wide range of valuations and 4) Tesla will see a significant run up in share price ahead of official S&P announcement because profitability driven S&P 500 additions are easier to predict than market cap based ones. This S&P share price bump is likely already happening to some extent, and if Tesla does enter the S&P 500 after Q120 or Q220 it will be sustained, and if it does not and Tesla no longer looks likely to meet last twelve months profitability in the near future, then this S&P bump is likely to reverse.
But how many new shares will actually be bought (and effectively taken out of circulation) by passive investors?
It is important to note Tesla shares are already held by many passive funds. In particular indexes which do not have a profitability criteria such as Russell, MSCI or Nasdaq indices. However S&P indices have the largest market share of passive investment for US companies.
The S&P 500 is market cap weighted and float adjusted, so in Tesla’s case Elon’s 34 million shares and the ~29 million synthetic shares created by shorts are excluded from share count. This means at current share price Tesla would be rated at a $64.5bn market cap, even though in reality investors and Elon are long $91.6bn Tesla equity equivalent.
The market cap of all S&P 500 companies is currently $28.7 trillion. The total market cap of all US equities is currently $36.1 trillion (the closest index to tracking all of this is the Russell 3000 which covers 98% of this market cap). This means Tesla would take 0.22% of all investment in S&P 500 passive tracker funds.
Passive investment consists of passive ETFs, passive Index Mutual Funds and passive Index Institutional funds. It is amazing how difficult it is to find good estimates on how much equity is held by passive funds, and how much of this is tracking the S&P vs Russell vs MSCI vs Others etc. The most detailed information I can find is in The Economist - According to its estimates these passive funds together held 29.8% of the market cap of the entire US listed equity universe, or ~$10.7 trillion at current levels.
What % of this $10.7trn is tracking the S&P 500, I don’t know.
When Twitter was added to the S&P 500 one investor estimated 78 million shares would be bought by passive funds following S&P inclusion, or 10-11% of the free float.
Twitter shares jump 5 percent as they win new follower: The S&P 500 If this is accurate it would mean ~$3.6trillion is held directly by S&P passive funds and ~15.5-16 million Tesla shares would be bought by passive S&P funds when Tesla is added to the index.
Another way to look at it is to look at ETF ownership of Tesla relative to S&P companies as a proxy for the broader passive investment market. Looking at some high profile S&P companies – these are the % of outstanding shares held by ETFs: Apple 6.2%, Netflix 6.2%, Google 5.0%, Amazon 5.2%, Nvidia 7.0%, GM 6.2%, Twitter 8.5%. This compares to Tesla at 3.2% currently. I would guess the variation between ETF ownership % in these various S&P companies is driven by inclusion in thematic or sector specific ETFs. Maybe it would make sense that Tesla would land somewhere between GM and Nvidia once it is in the S&P 500, or more than double the current ETF ownership. If this trend in ETF inclusion is a good proxy for Index institutional and Mutual Funds, then passive ownership in Tesla could double upon S&P 500 inclusion.
Overall I’d guess around 15-20 million additional Tesla shares will be bought by passive funds when Tesla is added to the S&P 500. If 20-25 million Tesla shares are already owned by passive Russell, Nasdaq or MSCI funds, then 35-45 million Tesla shares could be out of circulation due to passive fund ownership.
However, this is not the full picture…
Even within the Active Investor universe, fund performance is generally benchmarked to an equity index to track the fund’s performance relative to the market.
When an investor is benchmarked to an index, every variation between their own stock positions and the overall index is an active investment decision. Often it is easiest to mostly hold the same shares as the index, but to overweight or underweight certain shares that you think will give you an edge vs passive investment. So when a new company is added to the S&P, over time funds benchmarked to the S&P will look at that company to decide how they should be positioned in that company relative to the market cap weighted index.
Most US equity investors have so far avoided looking at Tesla, partly because it is complicated and takes a lot of work, partly because they have immediately dismissed it based off the media and equity auto analyst narrative. However many will be forced to start looking at Tesla because if they are benchmarked to the S&P then not owning Tesla will become an active investment decision. Many of these new potential investors will look at research from the Equity Auto analysts and uncritically buy into Tesla is just another ICE Auto company narrative, however many will have experience investing in tech companies and will see the fallacy of allowing a group of analysts with narrow expertise valuing mature, conservative and anti-innovation ICE companies to value a rapidly growing innovation machine.
I can’t see a current estimate, but this article says that in 2016 $2.9 trillion was invested in S&P 500 passive funds while another $5.7 trillion was benchmarked to the S&P 500.
S&P 500 evolves to reflect makeup of the economy - InvestmentNews So these active benchmarked investor’s capital is potentially twice as large as the passive investment capital.
So over time I’d expect S&P 500 membership to bring far more than just the 15-20 million direct forced passive fund Tesla share purchases. S&P 500 membership is a huge, huge catalyst for bringing new active shareholders on board and increasing the pool of active investment capital valuing or making gut feel investment decisions on Tesla stock.
The stockmarket is now run by computers, algorithms and passive managers
What will S&P 500 membership do for share volatility and beta?
It may be counterintuitive, but S&P 500 membership will actually increase volatility and increase beta. With more shares locked away by passive investors, it takes less to move the share price.
When the market is strong, passive funds will likely be buying which will tie Tesla stock price closer to the market direction (so increasing beta). But because Tesla is far harder to value than most companies, there is far less consensus on the correct valuation and a far broader range of valuation estimates relative to most stocks in the market. This means it takes less share purchases to move the stock price and beta will be higher than the market (so above 1) on days where there is no company specific news. Overall measured stock price beta will be lower than this because there is still going to be a lot more company specific news and catalysts (relative to most shares in the market) which can sometimes move Tesla in opposite directions to the market on days when this information is released.
Its also worth noting that S&P 500 membership provides yet another reinforcing feedback loop to stock price changes (in addition to the options delta hedging and short collateral calls I’ve discussed before). Because S&P 500 is market cap weighted, an increasing market cap (relative to the index) will mean S&P passive funds have to increase their shareholding in line with Tesla’s increased share of the index. This share buying will drive the share price higher which in turn drives more share buying to keep the market cap weighting. Much of this will be reflected automatically by the increased value of the existing shareholding, and the true effect of this feedback will depend on things such as stock issuance, share buybacks of other companies and rebalancing procedures etc.
What about debt and bond ratings?
I think @
jbcarioca mentioned a few weeks ago how debt ratings are also very significant. This is not connected to S&P stock inclusion, but bond upgrades are indeed going to be additional key positive milestones for the company, particularly when it reaches investment grade. I don't think its common for equity funds to be tied to debt ratings or investment grade, but it is very common for debt funds to be tied to specific ratings by their mandates and this can drive a powerful technical which reduces cost of funding as a company gets upgraded.
At Moodys Tesla as a whole is rated at B3 but its bonds are rated one notch lower at Caa1 because the bonds are subordinated to bank debt. These bonds would require 7 upgrades to get investment grade (or 21 upgrades if you include negative, neutral and positive outlooks for each level as separate rating levels). S&P rates both Tesla and its bonds at B- positive. So the bonds are already one level higher than Moodys but still 6 notches from investment grade (or 17 levels including outlooks).
So it still looks a long way away from investment grade, but every upgrade can reduce Tesla's cost of debt and multi level upgrades can happen very quickly if Tesla delivers a step change in profitability and EBITDA.
In July total outstanding debt of large US companies was $10 trillion while total corporate debt (including small medium sized enterprises, family businesses, & other non listed companies) was $15.5 trillion. Of this ~2/3rd was Investment Grade.
U.S. Corporate Debt Continues To Rise As Do Problem Leveraged Loans
So there is huge potential for Tesla to increase its debt as it increases its profits and increases its market cap. It can use this debt to fund accelerated capex, to fund acquisitions or to fund building its portfolio of solar and car lease assets. This is in contrast to most US companies that mostly issue debt to fund unproductive share buybacks, dividends or acquisitions rather than organic growth. So as Tesla increases its rating it will become more and more attractive to issue debt to accelerate capex and accelerate expansion and build out of a global renewable energy grid and electric car fleet.