The Nasdaq 100, QQQ, Facebook Nightmare

Buy low, sell high - at the most fundamental level, isn't that what we'd all like to do when investing? Then how appealing does it sound to buy an investment that, by design, might actually be doing the opposite? For a value investor, it's a nightmare scenario.

The recent inclusion of Facebook in the Nasdaq 100 index and, by extension, any ETF tracking it was an illustration of how the methodology for this index can play out. The index is based on the value of 100 of the largest non-financial stocks listed on Nasdaq. Inclusion in the list isn't automatic for the 100 biggest. A committee makes the picks, when stocks are removed due to bankruptcies, mergers, or other reasons. At one time, newly-public companies would not qualify, but the exchange has seemed willing to shorten the "seasoning period" if it means getting a listing. The juicy listing for Facebook's IPO inspired a change to just 3 months from the IPO, no doubt to draw the listing off competing exchanges. That three-month change is so new that Nasdaq hasn't updated their website <yet - it currently reads:

Initial eligibility criteria

  • the issuer of the security must have "seasoned" on NASDAQ or another recognized market (generally, a company is considered to be seasoned if it has been listed on a market for at least two years; in the case of spin-offs, the operating history of the spin-off will be considered); and
  • if the security would otherwise qualify to be in the top 25% of the securities included in the Index by market capitalization for the six prior consecutive month-ends, then a one-year "seasoning" criterion would apply.

Though a downloadable PDF< on the Nasdaq's index site has it right:

Initial eligibility criteria

  • the security must have “seasoned” on NASDAQ, NYSE or NYSE Amex (generally, a company is considered to be seasoned if it has been listed on a market for at least three full months (excluding the first month of initial listing).

The Nasdaq 100 is the basis of several ETFs. One of the larger ETFs in existence, ticker QQQ, is pegged to it, and it routinely is on the list of the most actively traded ETFs each day. Over $30 billion is currently invested in that ETF, putting it firmly in the top 10. And for the real speculators, there are 2X and 3X leveraged ETFs based on the daily price change of the index, and inverse versions as well. It gets a lot of attention, for what is really an oddball list of stocks.

Oddball? I think many QQQ investors and speculators would be surprised if they saw what they were invested in. Here's a recent holdings list:

Top Holdings of a Nasdaq-100 ETF (QQQ)

as of 12/5/2012, per ETF issuer website

 
Company Percentage
Apple Inc 17.02%
Microsoft Corp. 7.54%
Google Inc Class A 6.07%
Oracle Corporation 5.26%
Amazon.com Inc. 3.87%
Qualcomm Inc. 3.65%
Cisco Systems Inc. 3.47%
Comcast Corp Class A 2.63%
Amgen Inc. 2.31%
EBay Inc. 2.26%
Gilead Sciences Inc. 1.90%
Costco Wholesale Corp. 1.54%
Mondelez International Inc. 1.53%
Express Scripts Holdings Co. 1.48%
Starbucks Corp. 1.30%
News Corp Class A 1.28%
Biogen Idec Inc. 1.20%
Celgene Corp. 1.15%
Texas Instruments Inc. 1.14%
Priceline.com Inc. 1.12%
DirecTV 1.05%
Automatic Data Processing 0.93%
Vodafone Group PLC ADR 0.82%
Baidu Inc. ADR 0.81%

 

Baidu, at #25, seems as good a place as any to stop; it isn't all that big a company, and the list tapers off quickly after that to much-smaller companies than those closer to the top. Did you notice from the list above how top-heavy QQQ is? About half of its value is in just a handful of stocks. By the time you hit #25 Baidu, you've run through 75% of the value of the index. And this is better than it has been at times in the past, when Apple was over 20% of the index. It's not just Apple - it's the problem of having a capitalization-weighted index chosen from a list that has dozen or so gorillas, and a whole lot of mice.

In response to that problem, Nasdaq has created rules to limit the value that any one stock, or that the biggest stocks, can be in the index. It isn't strictly cap-weighted. Still, the history of the Nasdaq 100 has been that its performance is often dominated by a handful of companies. It's vulnerable to large moves by the stocks in its top-10, which can swamp the performance of the other 90% of the index.

That's enough about its overall composition; how are stocks added? Only non-financials listed on Nasdaq qualify. Given the sector mix of Nasdaq-listed companies, that probably means a company in the technology, biotech, telecom, or retail sectors. And among those, a substantial set of candidates for inclusion will be recent tech-stock IPOs. Not all of them, but there's a more or less constant pipeline of tech IPOs and most of them land on Nasdaq. The bigger ones will quickly float into the top 100 on the exchange (keeping in mind that you just need to beat up Baidu to get to #25). And having floated up, they'll be in contention for addition to the Nasdaq 100...as of 2012, as soon as three months after first trading.

Do you want to buy those companies? I don't - in fact I categorically avoid them. Not because they're all bad, but because it's simply too difficult to determine their real value and long-term prospects at that point in their company lives. The odds aren't very good. On average, a significant majority of these stocks eventually sell well below their original issue price. Not just below the post-IPO-runup price, but below the IPO price as well - possibly losing 90% or more of their bubble values. Maybe not immediately, but it's common within a year or two or three after the IPO. The New York Times did an excellent graphic< comparing a bunch of tech IPOs in May 2012. A lot of money chases these kinds of stocks, and a lot of the stocks fall, and many eventually go kaplooey.

But first...they can go up, a lot. And when that happens, they can get added to the Nasdaq 100 index. And if that happens, any QQQ shareholders buy right into that bubble stock at the inflated price. It can fairly be said that a long-term QQQ shareholder will be repeatedly buying into these stocks. So will other index-fund owners, but keep in mind that most indices aren't quite so top-heavy, and have longer seasoning periods before adding recent IPO stocks.

Now sure, the Nasdaq 100 index methodology isn't all bad. Those rules for paring back gorilla stocks are somewhat arbitrary, but the resulting index reconstitutions do have a nice "sell high" effect - at times paring back frothy stocks at a frothy moment. And companies added even shortly after their IPOs may go on to become very significant and profitable companies. Baidu for example has risen since its 2007 addition to the index, though it's fallen quite a bit recently. Google went public at a fraction of its current price so buying early paid off.

But Google is an exception and only a handful of companies have floated to the very top. What's curious is that a few stocks have now been parked at the top of the Nasdaq 100 for the better part of a decade. Pull up an old filing and you'll probably see Microsoft, Cisco, Intel and Oracle at or near the top. Depending on the timing, you might see Apple, Amazon and eBay too. Suggesting that all of the additions since have not found many of the future-gorillas.

Which brings us, finally, to Facebook. Facebook went public in May 2012 at an IPO price of $38/share, which valued the company at over $100 billion despite its limited revenues and profits. The stock closed a bit above that, but didn't have the "first day pop" that many claim is desirable for an IPO. Shortly after, the stock began to fall, and by the time of the first major IPO lockup expiration in late 2012, when many employees and investors had their first opportunity to sell, the stock was below $19/share - a loss of half of its value from the IPO price. But still, it remained at a very high market capitalization relative to sales and profits. Its value is all based on future possibilities.

Cue the addition to the Nasdaq 100. Will it happen at $19/share or below? Probably not. In just a few weeks since that lockup expiration, the stock has rebounded to about $27/share, possibly helped by news of this addition and the limited float for the stock. Time will tell what the buy-in price will be for QQQ holders, as the reconstitution won't happen until December 12. On the bright side, at least it wasn't added at the IPO price. And the indications are that the weighting in the index will be relatively small, about 1%. In part that's because so few Facebook shares are available to trade, but it's also because of that drop in share price since the IPO. Lower share price, lower market cap, lower weighting. It would have been worse if the stock had gone up.

Still, considering all of the investment alternatives out there at the moment, would you really want to make Facebook a new holding? Now, while the company is still not making much money, and has only vague descriptions of how it might ever earn more - yet is valued at over $50 billion? And right after the stock ran up nearly 50% from the last IPO lockup (when a bunch of insiders sold a large number of shares), with more lockup expirations coming soon? Maybe you would, if you're very much a growth investor and believe in buying companies that might become very profitable in the future. But not so much, if you're more on the value side of things and look to add stocks when they seem truly beaten-up, and are cheap relative to earnings, assets, or some other metric. In the world of technology, it isn't hard to find companies that meet that criteria now. In my view, Facebook isn't one of them.

I'd say the same of many of the additions to the Nasdaq 100 over the past decade and a half. And this isn't a quirk of the specific stocks, it's fundamental to the methodology for the index and the ETFs tracking it. Which might just make QQQ a value investor's nightmare ETF - an investment vehicle that systematically buys the exact types of stocks that value investors try to avoid.