I’m expecting four UK stocks to feature prominently in the financial news over the coming week. All are connected with the same event scheduled for next Wednesday (1st of December).
The companies in question are FTSE 100 members Darktrace and Johnson Matthey, and FTSE 250 stocks Electrocomponents and Dechra Pharmaceuticals.
The event in question is the publication of the final quarterly FTSE UK Index Series review of 2021.
How it works
For those unfamiliar with these reviews, a FTSE 100 company can suffer the ignominy of being relegated from the UK’s top index.
This is determined by its ranking by market capitalisation (share price multiplied by number of shares in issue) at the review date. Typically, relegation is due to the company’s share price having fallen significantly since the last review.
Conversely, a high-flying FTSE 250 firm (or recently listed stock with a big enough market capitalisation) can enjoy the kudos of promotion to the top tier.
I’ll run through the companies that could be involved in next week’s ‘reshuffle’, how a promotion or relegation could affect their share prices and what it all means for Foolish investors.
Ins and outs
I’m writing this based on Friday’s closing share prices and market capitalisation rankings. So, with several trading days left before the review, there’s still time for things to change.
Having said that, cybersecurity company Darktrace looks near nailed-on for relegation from the FTSE 100. Its ranking of 128 is far below the automatic exit level of 111. Blue-chip chemicals company Johnson Matthey sits at 111, so is also positioned to fall through the trapdoor.
Meanwhile, FTSE 250 firms Electrocomponents (distributor of electrical and industrial supplies) and Dechra Pharmaceuticals (veterinary medicines specialist) — ranked at 87 and 89 respectively — sit just above the FTSE 100’s automatic entry level of 90.
Darktrace joined the stock market just last April. Its share price climbed so spectacularly that in October it replaced Morrisons in the FTSE 100 following the takeover of the supermarket chain by private equity.
However, sentiment was already beginning to turn against Darktrace. A research note from Peel Hunt raised a number of issues, including its valuation and that some customers had described its AI cybersecurity technology as ‘snake oil’.
Then, as soon as a post-IPO lock-up on insiders selling shares expired, a major shareholder dumped £64m worth. This was swiftly followed by a Darktrace director bagging herself over £9m from share sales. Needless to say, none of this has been supportive of the company’s share price and place in the FTSE 100.
The other relegation candidate, Johnson Matthey, suffered a one-day share-price fall of almost 20% on 11th of November. This followed the company announcing the retirement of its chief executive and intention to exit its battery materials business.
By contrast, a one-day rise of 6% on 4th of November and subsequent further gains have earned Electrocomponents a place for automatic promotion. The market welcomed the company’s news of a very strong first-half performance and further good momentum since.
Dechra Pharmaceuticals narrowly missed out on promotion to the FTSE 100 at the September index review. And it hasn’t required any major trading news to nudge it into an automatic promotion slot as we head towards next week’s review.
A stock-trading theory
Many investors believe that stocks promoted to the FTSE 100 will continue to perform well after going up, and that stocks relegated to the FTSE 250 will continue to perform badly after going down.
This is because the big FTSE 100 tracker funds are obliged to buy shares in the index’s new constituents and dump shares of those that have dropped out.
It’s a neat theory, but untidy in practice. Buying or selling a stock in anticipation of its likely promotion or relegation — and a few percentage points quick profit — simply doesn’t work consistently.
Foolish bottom line
The FTSE index reviews are necessarily of interest to tracker-fund managers, because they have to act on them. They’re also of interest to some short-term stock traders who believe they can second-guess which shares will go up a bit and which will go down a bit on the outcome of the review
But the interest is largely academic for us here at The Motley Fool. We’re focused on identifying great businesses that can deliver far more substantial returns for investors over the long term.
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G A Chester has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.