The wizards behind the curtain of the Standard & Poor's 500 Index did a little pre-spring cleaning yesterday, adding biotech biggie Biogen(Nasdaq: BGEN) and motorcycle maker Harley-Davidson(NYSE: HDI) to the closely watched benchmark. Getting the boot were two former market darlings from yesteryear, RV and manufactured housing supplier Fleetwood(NYSE: FLE) and engineering and construction services firm Foster Wheeler (NYSE: FWC). Predictably, the switcheroo sent shares of Biogen and Harley-Davidson higher this morning while Fleetwood and Foster Wheeler both fell.
Since the S&P 500 has pretty much evolved into a mutant index-cum-mutual fund in the past few years driven by the cream of the crop of American business in terms of return on capital and asset productivity, yesterday's news is not too surprising. Here's a breakdown of performance metrics for the four companies involved, based on their latest fiscal year numbers:
Ticker Operating Margin Return on Capital
BGEN 39.8% 24%
HDI 16.9% 17%
FWC 1.0% n/a
FLE 5.4% 13%
The rationale for the removal of Foster Wheeler and Fleetwood from the index was a "lack of representation," which sounds like a Revolutionary War-era battle cry. Officially, S&P says lack of representation means a company "no longer meets current criteria for inclusion and/or is no longer representative of its industry group." As Austin Powers' nemesis Dr. Evil might put it, "Rigghhhtttt." Investors who have witnessed past tweakings of the index know better. A lack of representation is code language for "these companies are not growing anymore, so let's replace them with a couple of companies that are growing faster than Jack's beanstalk."
What's interesting about the change is that Foster Wheeler and Fleetwood have not fallen completely off of S&P's radar screen. Rather, they have been relegated to the S&P SmallCap 600 Index, which includes companies with a median market capitalization of $473 million. From that standpoint, Foster Wheeler and Fleetwood fit the small capitalization bill, but investors should keep in mind that those two firms are far from being small companies.
In terms of revenues and total assets, Fleetwood and Foster Wheeler are just as big -- if not bigger -- than their S&P 500 replacements. But due to their lower profitability profiles and lack of fast-paced earnings growth, both companies can't come close to matching Biogen or Harley-Davidson in the market cap department.
This is an important point for index investors who may be thinking about diversifying their portfolios with small caps. Unfortunately, it is easy to mistake a small-cap index as a basket of small companies with bright future growth prospects in still-emerging industries. In the case of Foster Wheeler and Fleetwood, nothing could be farther from the truth. In fact, it can be successfully argued that a company like Biogen, despite its hefty market valuation, has more of the stereotypical "small-company, fast-growth" features that are often wrongly associated with a small cap.
The Street certainly sells small caps as tomorrow's fast growers, doing little to clear up the small cap/small company misperception. For investors seeking the growth opportunities that can be offered by small companies that are just getting started in their respective industries, the entire small cap vs. large cap debate should probably be junked. Instead, focus on the opportunities presented by each individual company and the ultimate price being paid. Great companies are great companies; what decile a company happens to fall into in terms of its market valuation is insignificant to its long-term investment performance.
