How are USA 500 Stocks Selected?

USA 500 Stocks
Image Credit: Capital Watch

While USA 500 may include only a small section of publicly traded firms, there is no doubt that it is one of the most important indices in the United States stock market.

Approximately 500 companies in the S&P 500 make over 80% of the stock’s total value on the market. Therefore, it is an important indicator of how the local market is performing.

If you target trading USA 500 stocks, one of the main questions that you might have in your mind is, “How are the companies selected to join the exclusive list?” Everything comes down to meeting a number of rules set by the committee of investors, and we are going to look at some of them:

Market Capitalization 

USA 500 was created to represent the largest companies in the US. So, size is an important parameter. The notion of “size” in the stock market means the selected company’s stock value or the total value of its shares (market capitalization).

Take the example of Apple Inc., an American multinational technology firm headquartered in Cupertino, California. In 2018, Apple made history as the first US firm to reach one trillion dollars in market capitalization, but Amazon’s and Microsoft’s also crossed the one trillion-mark by the end of the first quarter of 2019. By the close of September 2020, Apple’s shares were trading at about $115.

Another example is Coca Cola. The company has over 4.3 billion shares, which were trading at $41.9 by early October, meaning that its total market capitalization is about $180.1 billion.

The minimum market capitalization can move up or down, but the current number is $8.1 billion. Of course, this figure was way lower about 10 years ago, and you can expect it to continue increasing in the future.

Profitability 

When investors look for stocks, they put a lot of emphasis on profitability. This is why USA 500 and USA 30 indices give a lot of weight to the selected firm’s profitability.

To gauge the profitability of a company, there are two methods that are used; checking the profitability of the firm over the last one year (four quarters) and in the most recent quarter.

However, how profitability plays is very dynamic. In theory, if a company loses $200 million in the first three quarters of a year and then makes a profit of $700 million in the third quarter, it would still be considered profitable.

When considering profitability, companies that have just gone public are required to show their trading history for the past 12 months. This means that if you have just concluded an IPO, it is impossible to immediately hop into the USA 500 Index, even with a high market capitalization.

A Company’s Liquidity and Float should be Easy to Check

The goal of USA 500 is to correctly track the companies with large capitalization that you can invest in. In addition to large capitalization, firms that are only owned by a few individuals (closely held) or those with little trading volume (thinly traded) are disqualified. So, here is how this rule is applied.

To get your company into the S&P 500, your business is required to have more than 50% of its stocks being traded on the stock exchanges. This is a correct assertion because a company with 60% of the shares owned by the founder is more private than another firm where owners only hold 40%.

Besides a firm being publicly owned, it also needs to be liquid to join the S&P 500 index. To achieve this, the company is required to have a trading volume of more than 100% and to have traded no less than 250,000 shares in the previous six months. This implies that if a company has two billion shares, all of them must be traded every year.

Most of the top-rated companies in the US meet these requirements with ease, and it is the reason why they are always on the list or get their way back after falling off.

Companies that Get Free Pass into the USA 500

From the requirements that we have listed above, it is clear that they are pretty stringent, but there are some companies that get a free pass. These are the stocks that are part of other top-rated indices, such as the S&P MidCap 400 and S&P SmallCap 600. These stocks are exempted from the rules of float, profitability, and liquidity.

The argument for exempting these stocks is that if your company is already part of the exempted indices, it will have met most of the requirements for listing on S&P 500. Therefore, if you have a company and want to get your way into the S&P 500, one of the methods is joining the exempted indices.

Some Companies Cannot Get into the USA 500

Notably, S&P 500 only considers standard incorporations and REITs (real estate investment trusts), so other forms of companies falling outside the two categories are excluded. For example, companies with exotic structures, such as master limited partnerships (MLPs) and business development companies (BDCs) are excluded. Limited liability companies, exchange-traded funds (ETFs), and closed-end funds (CEFs) are also excluded.

S&P Goes beyond the Rules!

Notably, meeting the basic rules to join S&P 500 is not enough to join the index! The index committee must also give the nod for your company to join as a way of filtering firms that might want to take advantage of the index.

The active involvement of the index committee makes S&P 500 more active compared to others. For instance, Russel 100 only requires a company to meet the rules without subjecting it to an active committee.

When the USA 500 index committee strategically adds or removes stocks, it helps to ensure that the index does not differ significantly from what is happening on the market.

To get a company to get listed on the index, therefore, it must be performing well and maintain an upward trend on the market to impress the committee.

In this post, we have looked at the stringent rules that companies need to meet to get listed on the USA 500 Index. So, if you are a new trader, USA 500 companies can be a good consideration.

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