Berkshire Stock Split Fuels Speculation of S&P 500 Inclusion

Published on November 4, 2009

Many Berkshire Hathaway shareholders and other observers have been speculating that plans to split the company’s Class B shares 50-for-1 may result in Standard & Poor’s adding Berkshire to the S&P 500.  Standard & Poor’s maintains criteria related to trading volume that may have disqualified Berkshire in the past.  This raises the question of whether inclusion in the index makes any real difference for long term shareholders.

Glaring Omission

Berkshire Hathaway’s absence from the S&P 500 has long been a glaring omission given the size and importance of the company.  The S&P 500 seeks to act as a proxy for the U.S. equities market and focuses on large cap companies.  By any reasonable criteria, Berkshire should have been added long ago.  The trouble has been a lack of adequate trading volume due to low turnover and the high price per share of the stock.

From the perspective of more accurately reflecting the large cap U.S. equity market, including Berkshire Hathaway in the S&P 500 makes perfect sense.  More likely than not, Berkshire Hathaway will be added to the S&P 500 at some point in the not too distant future.

Does This Matter For Shareholders?

The question of whether inclusion in the S&P 500 matters for shareholders depends on the question of time horizon.  In the short run, index fund managers as well as the many mutual fund managers who are “closet indexers” will be forced to purchase shares.  This can have the effect of driving up share prices in the short run.  However, the impact may be smaller than in the past based on a recent study by William Hester of the Hussman Funds.

Mr. Hester cited research from Standard & Poor’s which found that companies added to the index earned 3.6 percent cumulative excess returns from the announcement date to the effective date over a two year timeframe.  However, this is down from a 9 percent excess return for companies added to the index in the late 1990s.  It appears that the “index effect” has become more muted over time as more investors attempt to profit from it.

S&P 500 inclusion should only matter to Berkshire Hathaway shareholders who are interested in liquidating shares in the short run.  It is likely that inclusion in the S&P 500 will create a small but short term effect in the stock price, but obviously other short term factors could carry more weight over the next few months.  Long term shareholders should be focused on Berkshire Hathaway’s intrinsic value, not short term price movements.  For such shareholders, S&P 500 inclusion is likely to be a non-event.

Consider S&P 500 Deletions For Possible Investment

Mr. Hester’s study contained interesting data regarding companies that have been deleted from the S&P 500 index.  Obviously, for each addition to the index, another company must be removed.  In some cases, removed companies may tend to have short term problems that have caused them to fail one or more of the criteria set forth by Standard & Poor’s.  In other cases, a company may be removed simply because Standard & Poor’s had to add another company deemed to be more representative of its industry.

Regardless of the reason for removal, it is likely that such companies are less popular than companies being added to an index.  This can create short term depressions in price that may or may not accurately reflect the underlying prospects for the business.  Mr. Hester’s study revealed that the price performance of companies removed from the index actually outperform new additions.  This counterintuitive finding may not surprise value investors who tend to search for companies that are unloved, unpopular, and may be facing short term difficulties that cause share prices to fall below intrinsic value.

Whether or not Berkshire Hathaway is added to the S&P 500 is a legitimate point of interest but value investors may want to pay more attention to which company is removed from the index to make way for Berkshire.  It may be just the type of unpopular company that presents opportunities for bargain seekers.

Disclosure:  The author owns shares of Berkshire Hathaway.

Berkshire Stock Split Fuels Speculation of S&P 500 Inclusion