The founder of Research Affiliates shares insights.
To date, the largest initial public offering was Saudi Aramco, which raised approximately $29 billion in 2019, achieving a total valuation of $1.9 trillion. It is projected that three companies—Space Exploration Technologies Corp (SpaceX), the AI firm Anthropic, and OpenAI—could collectively raise around $170 billion, with a combined valuation potentially exceeding $4 trillion.
Major index providers are currently re-evaluating their rules, with some aiming to facilitate the rapid inclusion of companies like SpaceX into mainstream indices. My firm operates the RAFI Fundamental Index, and as an index provider, I approach speculative rule changes with caution. S&P Dow Jones Indices recently stated it would not create special exceptions or alter existing rules for large IPOs. However, the precedent set by the inclusion of Tesla into the S&P 500 in 2020 remains a significant and cautionary tale for the industry.
S&P's criteria require a company to report positive earnings in its most recent quarter and have cumulative positive earnings over the preceding four quarters. This requirement delayed Tesla's inclusion, even though it had already become one of the world's most valuable companies. From the announcement of its pending inclusion on November 16 until its official addition on December 18, Tesla's stock price surged by 70%. What is less known is that investors had anticipated its inclusion months in advance. From its March low that year to its formal index inclusion, Tesla's stock appreciated nearly tenfold. Whether this assessment is fair or not, many industry insiders view the delayed inclusion as a notable misstep by the S&P Index Committee.
Index investing is now fundamentally reshaping market dynamics. To borrow an old American Express slogan: membership has its privileges. Once a company joins a major index, it attracts a wave of passive buying from funds that do not consider valuation. Index funds are compelled by their mandates to mechanically buy new constituents and sell removed ones, irrespective of the stock price. This creates a persistent flow of capital into index constituents.
I estimate that approximately $14 trillion in assets directly track the S&P 500 (excluding other assets benchmarked against it). An additional $4 trillion tracks the Nasdaq and Russell 1000 indices. With the total U.S. stock market capitalization around $80 trillion, these index funds collectively hold nearly a quarter of all U.S. equities, and an even larger share within their specific benchmark indices.
Consider a hypothetical scenario. If SpaceX goes public with a $2 trillion valuation, selling a 4% stake in the IPO, its total market cap would represent about 2.5% of the entire U.S. stock market.
If the S&P, Nasdaq, and Russell index committees immediately included the stock at its full market-cap weight, calculations suggest index funds would need to purchase over $500 billion worth of SpaceX shares. However, the publicly available float would only be worth about $80 billion. In theory, this could drive the stock price to exorbitant levels and destabilize the capital markets.
In practice, index inclusion does not work this way. New additions are typically weighted based on free-float market capitalization—the shares available for public trading. Under this rule, from the $80 billion float, index funds would need to purchase a maximum of roughly $30 billion in shares. This would cause significant market disruption but likely not a complete breakdown.
The market has the capacity to absorb massive IPOs. Furthermore, once a stock is included in a major index, it often enjoys a long-term valuation premium. Comparing the S&P 500 index to the S&P MidCap 400 index (stocks ranked 501 to 900 by market cap) reveals that since 2012, the S&P 500 has significantly outperformed the mid-cap index.
The traditional explanation is straightforward: the S&P 500 comprises America's best companies, while the rest of the market underperforms and disappoints. However, if we look beyond GAAP earnings and instead measure fundamentals using cash flow—a more accurate reflection of business health—a different picture emerges. Over the past 25 years, the average annual cash flow growth of S&P 500 constituents has been about 3 percentage points lower than that of S&P MidCap 400 constituents.
This finding is thought-provoking. The outperformance of large-cap stocks over the past decade is not due to faster business growth but rather investors' willingness to pay a higher premium for them. Even as their earnings growth has lagged, the valuation premium of these large-cap stocks relative to mid-cap stocks has expanded to approximately 80%.
The listing of SpaceX and other large companies will likely amplify the advantages of index inclusion, widening the valuation gap between index constituents and non-constituents. However, as long as the cash flow growth of leading companies continues to trail that of their smaller peers, investing in non-index stocks may offer superior long-term returns.
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