If you’re new to investing, you may be unaware that the FTSE 100 ? the index of the 100 biggest companies traded on the London Stock Exchange ? gets revised every 3 months. Just as a group of poorly performing football teams get relegated at the end of a season, that same thing happens to a group of businesses whose market capitalisation dips below a certain threshold.
Why is this a big deal? Simply because fund managers and index funds focused on the biggest and best known companies may need to sell their investments, thereby placing further pressure on the prices of…
If you’re new to investing, you may be unaware that the FTSE 100 — the index of the 100 biggest companies traded on the London Stock Exchange — gets revised every 3 months. Just as a group of poorly performing football teams get relegated at the end of a season, that same thing happens to a group of businesses whose market capitalisation dips below a certain threshold.
Why is this a big deal? Simply because fund managers and index funds focused on the biggest and best known companies may need to sell their investments, thereby placing further pressure on the prices of those involved. This, in turn, may lead those with smaller holdings (such as private investors) to jettison their shares out of fear that these businesses will struggle to recover.
With this in mind, let’s look at two companies that look vulnerable to relegation.
Share price slump
Despite benefiting from the dip in oil prices over the last year or so, airlines such as Luton-based easyJet (LSE: EZJ) have been hit hard in other ways. Terrorist attacks and air traffic control strikes have led many tourists to change their holiday plans. All that before the consequences of Brexit have even been considered. Collectively, these events have hit easyJet’s share price hard. Priced at 1627p exactly one year ago, they now trade at 1004p.
Although not a victim of external events to quite the same extent as its FTSE 100 peer, Royal Mail (LSE: RMG) has still come under pressure. Since reaching a 52-week high of 541p back in May, shares in the £4.58bn cap postal service have recently dipped to 455p after the company reported that letter volume had dropped by 4% — something the 500 year-old business attributes to weakening economic conditions after the EU referendum.
Based on valuations alone, I actually think that a descent into the FTSE 250 would be a great time to build or add to a position in either company.
easyJet’s shares trade on a rather cheap forecast price to earnings (P/E) ratio of 11.5 for 2017. Despite a reduction in the dividend, the yield still comes in at 4.3%, easily covered by earnings.
Royal Mail’s shares have an almost identical forecast P/E for 2017 and come with an even bigger 5% yield. Compare this to what you would get from your typical savings account and the rewards seem to outweigh the risks.
But it’s not just the attractive valuations that make me think these share are worth buying. While there are plenty of companies that don’t return to the FTSE 100 at a later date, that’s not to say it never happens. Just look at Morrisons. Relegated to the FTSE 250 in December 2015, the supermarket jumped straight back up in March thanks to its lucrative deal with Amazon.
Should our departure from the EU not be the nightmare some are predicting, the same could happen to either Royal Mail, easyJet or both. As always, its vital to look at the bigger picture when evaluating whether it’s worth hanging on to a particular investment.
So, while a descent into the market’s second league won’t be welcomed with rapturous applause, nor does it mean that private investors should automatically reduce their holdings in either company. Given time, I think sentiment towards easyJet and Royal Mail will return.
Paul Summers owns shares in easyJet. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.