BOSTON (AFX) -- Many investors who shunned Google's controversial open-auction IPO last year as too risky are kicking themselves after the stock's meteoric rise.
Now, whether they love the company's growth prospects or see the stock as overpriced as it trades in the $300 range, shares of the online search engine are poised to enter millions of investors' portfolios.
The reason? Market experts think Google Inc. may join widely-tracked benchmarks as soon as the end of the year, forcing index-funds and their legions of shareholders to snap up the stock.
"Google could be added to the Nasdaq-100 by the end of 2005, and right now the company meets all of the basic eligibility screens for inclusion in the S&P 500," said Steven Schoenfeld, chief investment strategist at Northern Trust Global Investments.
For many mutual-fund investors, the prospect of Internet bellwether Google joining the S&P 500 is a d?j? vu of sorts.
In the late 1990s, the index committee at Standard & Poor's in charge of maintaining the S&P 500 added many high-flying new economy stocks such as Yahoo Inc. and JDS Uniphase Corp. to the venerable index, replacing stodgier companies such as Pep Boys and Rite Aid Corp. .
Many commentators blasted the committee in the years following the Nasdaq's nosedive in 2000. They claim the board packed the S&P 500 with overvalued tech stocks just before the peak, and so are partly responsible destroying millions of dollars of investor wealth.
Conversely, the keepers of the S&P 500 are unapologetic, saying their job is simply to maintain a benchmark that's representative of the overall U.S. economy.
Not surprisingly, S&P was mum on the prospects of Google being added to the S&P 500 because it is secretive about its moves and tries to make index addition and deletion announcements in a random fashion.
Still, with a market capitalization of about $80 billion, most investment professionals see Google's addition to the S&P 500, and also the popular Nasdaq-100, as a given. The company also plans to sell up to 14.8 million shares in an offering that could raise more than $4 billion.
The development will affect countless investors when Google finds its way into their mutual-fund portfolios, and also has implications for the stock itself because companies often see their shares spike when they enter closely tracked indexes.
Elite clubs
Given the rise of indexed strategies over the past decade and the flood of money flowing into passively managed index funds and exchange-traded funds, predicting benchmark changes has become something of a cottage industry.
For example, about $1.2 trillion is directly tied to the S&P 500 through index funds, ETFs, and other vehicles, according to S&P. Additionally, over $3.5 trillion is benchmarked to the index.
Meanwhile, the Nasdaq-100 is a common benchmark for technology-portfolio managers and is also the tracking index for the fashionable Nasdaq-100 Trust known as "cubes" -- one of the largest U.S. ETFs and frequently the most highly traded security on any given day.
According to the eligibility guidelines for the Nasdaq-100, a stock must be "seasoned," or listed, on an exchange for at least two years. However, there is a "fast track" provision where securities that would land in the top quarter of the index for the six prior consecutive month-ends can be included in the Nasdaq-100 after only one year.
Since the Nasdaq-100 rebalances annually shortly after mid-December, Google could be in line to join the index as early as the end of 2005.
The outlook for Google's inclusion in the S&P 500 is less certain since the index committee's stamp of approval involves some subjectivity.
According to S&P's Web site, initial public offerings should be seasoned for six to 12 months before being considered. S&P also has a "financial viability" requirement where companies must post four consecutive quarters of positive earnings, so Google qualifies on both counts.
However, S&P's "sector balance" mandate to reflect the broad stock market is more nebulous, and provides the index committee with some wiggle room.
David Blitzer, head of S&P's index committee, said the fastest that a company like Google, which has a significant chunk of insider shares, has been added to the S&P 500 is just over one year after the IPO.
Although he acknowledged "some of the companies we added to the S&P 500 in the late 1990s fell apart," Blitzer said the board's decision on Google will not be influenced by how other technology and Internet stocks faired after they were added to the index before the 2000 correction.
Jon Markman, a portfolio manager at Greenbook Investment Management, is one of the most vocal critics of Blitzer and the other committee members. He has written many commentaries over the years claiming the S&P 500 is not the objective benchmark it's widely perceived to be, but rather an actively-managed portfolio, and a poorly-managed one at that.
"S&P was highly embarrassed back in 2000 when they put a bunch of high-fliers in the index at their peak," Markman said in an e-mail, but added the committee will have to take Google into the S&P 500 "fairly soon."
He speculated Blitzer and company may be waiting for a selloff, perhaps sometime in the fall, to add Google at a lower price level.
"Or they may be waiting for a convenient merger to take out a tech name," Markman added.
Further complicating matters is that S&P is in the midst of some big methodology revisions to its stock indexes, which could make adding Google particularly messy.
S&P is halfway through a move to "free-float" weighting that is set to wrap up in September. In float-adjusted indexes, a company's individual weight is determined by only shares available for purchase on public markets, excluding shares held by company insiders, for example.
Furthermore, S&P is scheduled in mid-December to completely overhaul its "style" indexes tracking the growth and value components of the market.
"That might be a good time for Google to go into the S&P 500," said Schoenfeld at Northern Trust. "The committee has to ask itself if the S&P 500 truly represents the large-cap market without Google."
If Google went into the S&P 500 at its recent levels, it would be No. 62 in terms of size and would represent about 0.4% of the market cap of the index, Schoenfeld added.
At that level, adding Google "won't represent a remarkable change to the overall risk profile of the S&P 500, and that's the beauty of a broadly-based index," said Gus Sauter, chief investment officer at index-fund giant Vanguard Group.
And since the index is designed to measure the performance of large-cap stocks, it makes sense to add Google regardless of whatever effect it may have on performance, he added.
"Google is a logical candidate for the S&P 500, whether it's overpriced or not, and only time will tell if it is," Sauter said.
Yahoo, the sequel?
If Google finds its way into prevalent indexes, it could have an effect on its share price as well, particularly if the company passes muster with the S&P 500 committee.
Shares of public firms slated to enter the index typically see the price move higher between the preliminary announcement date and the day the stock is actually added. Known as "index effect," the reverse often happens when a stock is booted from the S&P 500.
The phenomenon underscores the considerable power wielded by the nine-person committee at S&P, whose closed-door meetings reportedly involve a level of secrecy that would make the CIA envious.
For example, back in 1999, S&P on Nov. 30 announced it planned to add Yahoo to the S&P 500 after the close of trading on Dec. 7.
The stock closed at $212.75 on the announcement date, but in one week rocketed to $348 a share, an increase of 63.6%, although the company's fundamentals remained unchanged.
So what happened?
Essentially, hedge funds and other aggressive traders, aware that index-fund managers had to buy Yahoo to keep pace with the S&P 500, bid up the shares hoping to unload them on the "dumb" index funds later at a profit.
The effect was magnified by a supply crunch -- there weren't enough Yahoo shares to go around since much of the stock was held by company insiders. This hurts index-fund investors because they end up paying a higher price than they normally would; hence S&P's decision to move to free-float weighting.
Blitzer at S&P noted Yahoo's surge was partly due to a lack of ownership by large institutional investors. Instead, a lot of individual investors held small chunks of the company.
"So when index funds went to purchase the stock they weren't able to buy Yahoo in big pieces," Blitzer said. "Instead they had to do hundreds of small trades, and that seems to have contributed to the runup in the stock price."
On the other hand, institutional investors and hedge funds are major holders of the Google stock, so the volume should be there if the company enters the S&P 500, said Schoenfeld at Northern Trust, who has penned a tome on index-fund management.
He figures S&P 500 indexers would be required to buy 16 million shares of Google, or about eight times the average daily volume.
"Part of the reason you won't see a repeat of the sharp spike in Yahoo is that it went in at full market cap but it had only 10% float, and thus there was an extreme supply/demand imbalance," Schoenfeld said.
In contrast, Google would go into the index at a float-adjusted weight.
Last year S&P released research showing so-called index effect for the S&P 500 has been steadily decreasing over the years, in part because index-fund managers have developed more complex trading strategies to combat the problem and keep opportunistic traders off balance.
"Google would be a big addition if and when it goes into the S&P 500, but the liquidity is there and we wouldn't expect a major index effect," Schoenfeld said.
This story was supplied by MarketWatch. For further information see www.marketwatch.com.
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