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The S&P 500 is one of the world’s best-known equity market benchmarks, but it may have just become a little harder for companies to qualify for inclusion in the index.
On July 31, S&P Dow Jones Indices, the outfit that oversees the S&P 500 and its constituency, announced that it would take steps to exclude companies with multiple share class structures. It’s a move that might seem minor on the surface, but, in reality, it has wide-ranging effects for both the companies that have multiple share classes and the index funds that benchmark to the S&P 500.
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The move comes amid blowback from investors who have complained about company practices that are designed to keep majority, or total, voting control in the hands of its management and founders. Google (GOOG) is a prime example of this practice. It currently has three share classes. The Class A shares, which trade under the ticker ‘GOOG,’ are publicly traded shares that come with one vote each. The Class C shares, trading under the ticker ‘GOOGL,’ have no voting rights at all. The Class B shares, which are privately held and owned mostly by Google insiders, each get 10 votes. A structure such as this is a clear attempt to keep company decision-making in-house and out of the hands of external shareholders. Snap Inc. (SNAP), which had its IPO earlier this year, took it one step further by only issuing shares that came with no voting rights.
The S&P decision will apply to index inclusions going forward, and will not be applied retroactively. Companies such as Google, Facebook (FB) and Berkshire Hathaway (BRK-A) will be grandfathered in and remain in the S&P 500. A company, such as SNAP, that is not currently part of the S&P 500 will not be eligible for inclusion until it changes its share structure. FTSE Russell announced a similar plan for its indices. Going forward, eligible companies need to have at least 5% of voting rights held by the public. Companies with multiple share classes already in one of the indices will have until September 2022 to change their structures or face removal.
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Quite simply, investors want greater control over company decisions. Whether it’s electing a board of directors or deciding on company direction, investors want a say in how the companies they own are run. This applies, especially, to large institutional and activist investors. These ultra-wealthy shareholders often take positions in a company to try to force a change. For example, in 2014, Carl Icahn used his 53 million share stake in Apple to try to get the company to increase its share buyback program to take advantage of what he perceived was a valuation disconnect. A company that only issues no-vote shares takes this power out of the hands of shareholders, and potentially makes an investment in the company look less attractive.
From an oversight perspective, the move by S&P is a way of discouraging the practice. With so much money tied up in passively managed strategies, companies that get excluded from the S&P 500 face the loss of millions of dollars of potential investment. For instance, SNAP provides a good case study for what could happen being on the outside looking in. The announcement of the S&P 500 exclusion came at the same time as its IPO lockup expiration, but the stock dropped more than 8% from just before the announcement to just after. FTSE Russell has already booted SNAP from its indices. Exclusion from the market’s biggest indices also has the potential of acting as a ‘scarlet letter’ by telling shareholders that the index providers don’t approve of what the company is doing.
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There are roughly $8 trillion in assets benchmarked to the S&P 500. While the Googles and the Facebooks of the world are grandfathered into the S&P 500, the next huge growth story could be left out if it issues a non-compliant share structure. Investors who choose the S&P 500 largely do so because they want exposure to all of the biggest and best companies in the world. If a company, such as Google, were not part of the S&P 500, investors would either have to buy individual shares of the company on their own if they want exposure, or accept that these companies won’t be a part of their portfolio.
Companies issuing share structures designed to keep voting control in-house has become an increasingly prevalent practice, but that might be starting to change. It’s unclear if the decisions by S&P and FTSE Russell will be enough to help eliminate these unfriendly shareholder structures, but it’s received enough attention that it could ultimately promote wider-scale changes. The decision to prevent these companies from making it into the broader indices is a positive development for the average investor.