Why care about MSCI index?

What is  the MSCI EM (Emerging Markets) index and why do stock market professionals pay close attention to any changes in the index constituents?

Based on the description provided by Bloomberg, “the MSCI EM index is a free-float weighted index that captures large and midcap representation across emerging market or EM countries. The index covers about 85 percent of the free float-adjusted market capitalization in each country (that are part of the EM basket).”

Because it is “free-float weighted”, focused on “large and midcap representation” and covers “85 percent of the free float-adjusted market capitalization” of countries that are part of the EM basket, an investor with a large portfolio can easily buy and sell stocks that are part of the index. The performance of his portfolio will also be a good representation of how stocks in emerging markets performed. As such, the MSCI EM Index is widely followed by institutional investors that are tasked to invest in emerging markets.

Although retail investors don’t have large portfolios that need to track the performance of the index, they still need to pay close attention to changes in the MSCI EM index as it provides them an opportunity to generate excess returns or reduce losses in the short-term.

As discussed earlier, the MSCI EM index is widely followed by institutional investors. Therefore, if a stock is added to the index or if its weighting is increased (ex., from 3 percent of the portfolio to 5 percent), institutional investors have no choice but to increase their holdings of the said stock. On the flip side, if a stock is removed from the index or if its weighting is reduced, they also have no choice but to sell or reduce their holding of the said stock.

Note that the said actions are done without taking into consideration the stock’s fundamentals or valuations since the main objective of institutional investors is simply to comply with the new index weightings by the set deadline. Consequently, the temporary increase in prices of stocks that are added to the index which are unsupported by fundamentals creates opportunities for retail investors to lock in gains, while the temporary drop in prices of stocks that are removed from the index but is unwarranted by fundamentals creates opportunities for investors to buy cheap.

The components of the MSCI index are changed or rebalanced consistently on a quarterly basis— February, May, August and November. For the rebalancing in May, notable changes include the following:

An increase in the weight of SM Prime (SMPH)

The addition of Integrated Micro Electronics (IMI) and Macroasia Corp. (MAC) in the MSCI small cap index. The deadline for compliance is on Thursday, May 31.

In our opinion, investors who own shares of SMPH, IMI and MAC should take advantage of this opportunity to lock in gains on the three stocks and just buy them back later at a cheaper price.

After the announcement that its weighting in the MSCI index was increased, the share price of SMPH rallied by 6.6 percent to P38.   Although we like SMPH fundamentally, we think the stock is already fairly valued. At P38, SMPH is currently the most expensive property stocks in the PSE, trading at 33.2X 2018 P/E (versus the 20.9X sector average) and less than 10 percent below its net asset value.

It is also trading at par with our fair value estimate and remains to be one of only a handful of stocks in the PSEi that are still currently trading above their 10-year historical average P/E.

Meanwhile, both IMI and MAC disclosed weaker than expected first quarter earnings. IMI’s core profits in the first quarter of 2018 fell by 24 as costs went up due to the shortage of electric components in the industry, a trend that is expected to continue for the rest of the year. On the other hand, MAC’s first quarter profits fell by 22.3 percent as it was hurt by the poor performance of its affiliate Lufthansa Technik Philippines and the significant increase in the costs of its ground handling business. Both companies are also expensive in terms of valuation as both are trading at a premium relative to the average P/E of their peers.

Normally, companies that trade at expensive valuations suffer from steep corrections after they disclose weaker than expected earnings. However, the share price of IMI and MAC have been resilient after they were added to the MSCI small cap index. We don’t expect this resilience to be sustained though once the May 31 deadline passes. As such, we advise investors who still own the two stocks to lock in gains for now.