How to profit from PSEi changes

Last Thursday, the Philippine Stock Exchange (PSE) announced that AC Energy (ACEN) and Converge (CNVRG) would be added to its 30-member PSE index. To make room for the two stocks’ addition, DMCI Holdings (DMC) and Emperador (EMP) would be removed. These changes would be effective on Aug. 16. Note that many local institutional investors use the PSEi as the benchmark to measure their funds’ performance. Therefore, if a stock is added to the index, these fund managers have no choice but to buy the said stock. On the flip side, if a stock is removed from the index, fund managers have no choice but to sell their holding of the said stock. Otherwise, they would risk increasing their funds’ tracking error which would be viewed negatively by investors. It is no surprise then that last Friday, the prices of ACEN and CNVRG jumped by 4.7 percent and 11.5 percent while those of DMC and EMP fell by 6 percent and 8.9 percent, respectively. Although retail investors don’t have large portfolios that need to track the performance of the PSEi, paying close attention to changes in the PSEi members provides them with an opportunity to generate excess returns in the short-term.

Note that stocks are added or removed from the PSE index because of their size and liquidity. This is done without taking these stocks’ fundamentals or valuations into consideration. Consequently, it is possible for less than perfect companies with expensive valuations to be added to the index just because of size, and for good companies with cheap valuations to be removed just because they no longer belong to the top 30 biggest stocks in the PSE. For retail investors, the temporary increase in prices of stocks that are added to the index which cannot be justified by fundamentals creates an opportunity to lock in gains at much higher prices, while the temporary drop in prices of stocks that are removed from the index but are unwarranted by fundamentals creates an opportunity to buy at a large discount.

Since 2012, there were 11 stocks that were added and removed from the PSEi. Based on COL Financial’s analysis of the price action of these stocks, the prices of stocks that were added to the index increased by a median rate of 7.1 percent from the date that the change was announced to the date that the change was effective. However, one month and three months later, the prices of the said stocks dropped by a median rate of 3.7 percent and 9.5 percent, respectively. Moreover, nine out of the 11 stocks that were added rose from date of announcement to date of effectivity, while 10 out of those 11 stocks fell one month and three months after the date of effectivity.

Meanwhile, the prices of stocks that were removed from the index fell by a median rate of 2.7 percent from the date that the change was announced to the date that the change took effect. However, one month and three months later, the prices of the said stocks increased by a median rate of 1.9 percent and 2.9 percent, respectively. Moreover, nine out of the 11 stocks that were removed fell in price from date of announcement to date of effectivity, while seven out of those 11 stocks rose one month and three months after the date of effectivity.

Given this, investors who own shares of ACEN and CNVRG can take advantage of their strong short-term performance to lock in gains and just buy them back later when prices go down. Although ACEN and CNVRG are good companies, they are very expensive in terms of valuations. Note that based on last Friday’s close, ACEN is already trading at 31 times its projected 2023 earnings, while CNVRG is trading at around 15 times its project 2021 Ebitda (earnings before interest, taxes, depreciation and amortization) or pretax cash earnings. Other listed companies in the power and telecom sectors are currently trading at much lower multiples compared to the two companies.

Investors can take advantage of the short-term weakness of DMC to buy the stock. Admittedly, DMC is suffering from poor investor sentiment because of its exposure to coal mining. However, its profits are projected to more than double this year because of rising coal prices. Its power generation business will also benefit from the tight power supply situation. Finally, the stock is very cheap, trading at only 12 times its projected 2021 earnings, with insiders buying the stock even before the latest sell-off.

As for EMP, we are less confident about buying the stock even if its price goes down because of its removal from PSEi. This is due to the company’s more expensive valuations.