Changes
The FT-SE 100 index is about to undergo one of its biggest shake-ups, whose ramifications may not yet be fully appreciated, it was announced in early 2000.
First, the index has decided to allow subsidiaries to be included. This means that three companies are now eligible: Cable and Wireless Communications, Freeserve and Thus. Previously, subsidiary companies were excluded because this would double-count their share value if the holding company was also listed.
Second, the quarterly review of which companies to include is expected to make one of the largest changes. Details were not known when this edition went to press, but it is believed that as many as seven companies could be replaced. Outgoing companies would include utilities and older “smokestack” businesses which are out of favour with investors. Twelve such FT-SE 100 companies have seen their values fall by more than 40% in the last year. Powergen is down 55%. Incoming companies are technology companies including the “dot.com” companies or so-called Internet stocks.
Third, the index is moving from full market capitalisation to free float adjusted capitalisation. This applies immediately to new companies joining the index, and will apply to all companies in the index from June 2001.
Free float adjusted shares means that market capitalisation is determined solely according to what shares are freely available for purchase. If 20% of shares are still held by a family or the original holding company, only 80% of the market capitalisation will be considered for inclusion in the index. This means that the double-counting of including subsidiaries is avoided.
The FT-SE 100 index represents the 100 largest companies by market capitalisation. This is reviewed each quarter. There is a buffer zone from numbers 90 to 110 so that a company whose position fluctuates from 99 to 101 does not keep popping in and out of the index. A company must be at number 90 to be included and must be at number 110 to be excluded. Between those numbers, a view is taken.
Internet stocks
The three changes means that the index is likely to include more of these new technology companies and fewer of the old industries. This will make the index more volatile. When banks became flavour of the month in 1998, price-earnings ratios soared above 25, when 10 would have been considered excessive a few years earlier. This latest change makes the market even more volatile. Many of the Internet stocks do not even have a price-earnings ratio because they have no earnings. The popular Amazon.com is not expected to make a profit for at least another three years. The Internet stocks are being valued on the more intuitive “mindshare” basis.
Mindshare assumes that Internet trading is the massive business of tomorrow, and looks to see how all these new companies are placed to carve out their share. It can immediately be seen that there are two unknowns: how big the Internet cake will be, and how big a slice each company can carve for itself. So far, predictions of the Internet replacing shops and conventional trading arrangements have yet to be realised. Collective human behaviour is notoriously fickle, and there are many examples of good ideas failing because they did not catch the public imagination.
The herd instinct on the stock exchanges is likely to exaggerate this effect. So if the Internet stocks do crash, it is likely to be spectacular.
To give an idea of how highly valued these dot.com companies are, The Daily Mail calculates that Microsoft, Cisco, AOL and Yahoo! would have to increase profits by 30% a year for the next 20 years to justify their current market capitalisation.
Implications
There are many implications for businesses about this new volatility to one of the main economic indices.
First, it will put pressure on other companies for their performance to match the index. In the short term at least, volatility means bigger numbers. Companies could feel obliged to acquire, economise and follow dividend policies which may not be in their best long-term interests.
Second, pension funds may feel obliged to invest in the Internet stocks, putting the funds at a higher level of risk. If the Internet stocks crash, this could have serious consequences for the employer.
Third, companies needing investment could find sources more difficult if the present love-in with Internet stocks continues.
Fourth, companies now out of favour risk being prey for takeovers. Even for companies not directly affected, this could lead to significant reordering of markets.
There are undoubtedly many more implications and knock-on effects. The important factor is to watch what happens.
[2000]