The changes I wrote about in Part 1 are very typical of the upgrading that goes on within the index all of the time. For example, earlier this month Skyworks Solutions (SWKS) replaced Petsmart (PETM). The latter got a terrific private equity bid and the former may be among the hottest semiconductor companies out there, levered to the cellphone NOT the personal computer.
In January, HCA (HCA), the giant hospital company and biggest beneficiary of the Affordable Care Act, took the place of Safeway, which got a big bid from the privately-controlled Albertson's.
Then like Henry Schein for the acquired Carefusion trade, Endo International (ENDP), right up there with the red-hot Actavis (ACT) and Valeant (VRX) and currently vying for Salix against Valeant, subs for Coviden, which struck gold in its merger with Medtronic (MDT), getting a 29% premium bid from the device company. The changed tax status has only enhanced the value of Medtronic, as it now pays much less via the tax inversion that Medtronic availed itself of before the change in the laws.
On Dec. 4, the fast-growing travel company Royal Caribbean (RCL) replaced the plodding Bemis (BMS), a packaging concern. In November, Level 3 (LVLT), a content distribution company that many thought wouldn't make it after taking down so much debt in the late 1990s, replaced Jabil Circuit (JBL). This is another one of those sub rosa upgrades because Jabil, which was once a very-fast-growing contract manufacturer, has had stalled and halting growth for years while Level 3 is benefitting from the Netflix (NFLX) revolution.
Or take the changes from Nov. 8, 2014 when Mallinckrodt (MNK), one of the fastest-growing and most acquisitive drug companies, itself a spinoff of Covidien, subbed for Rowan (RDC). What a monumental change this has been, as MNK keeps filling out its franchise and has already risen 25% this year. Rowan's been a disaster since it left, as befits a contract oil drilling company with gigantic drill ships in its portfolio. The surfeit of those is legion, hence why its stock has cratered 22% this year. You have to wonder, with that switch, how PASSIVE the S&P 500 really is. That isn't luck.
Finally, let's consider the case of the switches on Sept. 19, 2014, when the S&P added two companies: United Rentals (URI), a construction-related company with a business model that makes it much more advantageous for small businesses to rent, rather than buy, equipment and Universal Health Services (UHS), an acute hospital chain that's also a big beneficiary of the Affordable Care Act.
They replaced two companies that almost no portfolio manager would care for, Graham Holdings (GHC), which is a vacuum and heat transfer manufacturer that was left behind when Graham sold the Washington Post to Jeff Bezos, scoring a big gain before it exited, and Peabody Energy (BTU), one of the largest coal companies on earth when that fuel has become Public Enemy No. 1 worldwide. No wonder its stock is down 29% for the year. Graham's also down 14% for the year. United Rentals hasn't been a standout this year, down 13%, but United Health has gained 2.5%. More importantly, these two are huge quality upgrades vs. Graham and Peabody.
I can go back for years and see this pattern over and over again: spent names being sent down to the minors, or big winners where the takeover accrued to the index, being replaced by rising stars with many good years ahead of them. It's a model that works and it explains much about why it's tough to beat the S&P, because the darned thing upgrades in constant fashion in an active, not at all passive, form despite its reputation for brainlessness.
In short, it's anything but. No wonder no active mutual fund can beat it consistently. It's about as active as it can be with the best farm team, the smartest retirement system and a fabulous exit strategy for the best of the best.