Snap (SNAP) shares fell even farther on Tuesday, widening its lead in the competition for the “worst IPO of 2017” sweepstakes:
At fault for the latest decline is S&P Global’s (SPGI) decision to exclude companies with dual-share classes from their indexes going forward. This decisions seems obviously targeted at Snap, which is the largest IPO in recent memory to go public without giving its shareholders any voting rights whatsoever.
S&P, in discussing the decision, stated that:
Companies with multiple share class structures tend to have corporate governance structures that treat different shareholder classes unequally with respect to voting rights and other governance issues,
This follows up on the FTSE Russell index manager’s recent decision to exclude Snap stock from their stable of indexes as well. This is an important development in several ways.
Snap Frozen Out Of Lucrative Passive Investing Market
Given the rise of passive investing, it’s increasingly important that companies be able to access the flood of ETF money that has been powering the market’s rally in recent years. ETFs now have $1 trillion more in assets than hedge funds – and the gap continues to widen. While hedge funds are thought of as the secretive force that can cause a company’s stock to succeed or fail, increasingly it is ETF flows that actually drive short-term stock price moves.
The flagship SPDR S&P 500 ETF (SPY) itself has $243 billion in assets. Assume that the S&P 500 would have given a modest 0.1% allocation to Snap – if not for the lack of voting rights – and the SPY ETF would have allocated around $250 million to SNAP stock. That’s enough to buy 19 million shares at today’s prices.
Latest short-selling data shows that shorts have bet against 69 million shares of SNAP stock. We can see how the S&P 500 ETF being forced to buy 19 million shares due to indexing rules could have caused a run on the shorts and helped sop up a lot of supply in SNAP stock heading into the lock-up expiration. Add in other index ETFs with smaller asset bases than SPY, and the effect could have been quite large.
Instead, due to Snap management’s intrepid decision not to give any voting rights to its shareholders, the company won’t benefit from any meaningful amount of passive index-fund based buying. Not surprisingly, SNAP stock plumbed new all-time lows on the news.
Good News For Passive Investors
This decision will hardly be appreciated by Snap’s shareholders. However, for the broader investing world, this is great news. I cynically expected Snap stock to perform relatively well – see my “Why Snap Isn’t Collapsing Yet” article from March. I’m pleased to have been wrong.
The fact is, most seasoned investors knew Snap was a terrible company out of the gate. Many people (including myself) didn’t short the firm, since we figured a combination of tech hype, uninformed millennial investors, and me-too passive money would flood into the stock, keeping it afloat at least until the share lock-up.
However, much to my surprise, Snap’s decision not to offer voting rights appears to actually have had consequences. After both Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL) and Facebook (NASDAQ:FB) got away with giving investors a much smaller voting share than management, it appeared this sort of behavior would be tolerated – if not openly accepted. Whether it was Snap’s poor economic performance, or its complete shunning of voting rights; in any case, the envelope was pushed too far, and the index managers decided to exclude Snap.
Passive investing has a number of drawbacks. That’s a subject too large for this column, but let me focus back in one concern that I’ve raised previously – ETFs buying stocks in sham companies solely due to market-cap weighting. In January 2016, I wrote:
Take LionGold, a Singaporean sham company that briefly found itself as the largest component in the gold mining junior (NYSEARCA:GDXJ) ETF. Once its stock scheme unraveled, the shares lost virtually all their value. GDXJ lost around 5% of its value due to the stinker company it had bought into heavily. Active investors in gold miners outperformed simply from avoiding the dud. And active short sellers got an inflated stock to beat like a piñata.
A similar fate befell the solar ETF (NYSEARCA:TAN) [in 2015]. Its top holding was Hanergy (OTC:HNGSF), which appears to have been a fraud. TAN put a full 12% of its fund into the company, taking a massive loss along the way. This sort of fiasco is inevitable with market-cap weighted indexes, and offers great opportunity for active investors. If indexing becomes much more prevalent than it is today, opportunities for active investors to pick off bad index components will multiply.
While Snap is a slightly different example from this sort of passive investing flaw described above, it shows the types of problems that arise from money being doled out simply based on market caps. The larger a company grows, the more money passive investors are forced to throw at it simply due to index construction.
For indexing to keep working, the index managers need to implement controls to keep companies that would abuse the system from gobbling up uninformed investors’ money. In some cases, such as pumps & dumps, some sort of quantitative quality screen should be implemented that tries to exclude fly-by-night stock promotions. For others, such as Snap, judging management’s allegiance to shareholders is of pivotal importance. If management isn’t aligned with common stockholders – by denying them voting rights, taking excessive stock option comp, or otherwise consuming too much of the pie, then the passive indexes should exclude them.
As passive indexing continues to grow, the managers must do more to protect their ETF stakeholders. There are a lot of underhanded management teams out there – let’s not pretend that the US market is squeaky clean. And they can and will take advantage of the opportunities that come with forced allocations into their stocks from passive investors – unless the index managers take steps to filter out low-quality and/or shareholder-unfriendly firms.
Snap in particular is a great test case, since more and more tech unicorns are going public nowadays. And the latest batch are showing ever-weaker fundamentals and more questionable business models. We’re hardly back to 1999 yet, but underwriting standards are falling. Forward-looking moves from Russell and S&P Global can help protect investors and keep markets relatively more fair than they’d otherwise be.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.