(Bloomberg) — In recent years, AppLovin Corp. has captured attention in the U.S. stock market.
The mobile advertising technology firm’s stock has surged over 5,500% since the close of 2022, making it the second-best performer in the Russell 3000 index, with Carvana Inc. taking the lead. Its market cap skyrocketed from $29 billion at its public debut in April 2021 to over $200 billion today. It’s no surprise that the company was included in the S&P 500 index last month.
At first glance, AppLovin resembles a typical tech company. But there have been some lingering doubts about its operations.
Short sellers have raised allegations against AppLovin, claiming advertising fraud, illegal tracking of children, and undisclosed connections to Chinese firms. Additionally, the U.S. Securities and Exchange Commission is investigating the company’s data collection practices regarding compliance with advertising regulations, prompting a halt on some related products. The New York Post reported that several state attorneys general might also be looking into the matter.
This begs the question: Did the S&P make a mistake by including AppLovin? The quick answer is no. An index isn’t a stamp of approval; it reflects the current landscape of stocks. David Blitzer, former head of S&P’s index committee until 2019, stated that there wasn’t a requirement to evaluate every company annually.
The S&P 500 has requirements for size, liquidity, and profitability. Unlike many broad equity indexes, it does not incorporate quality or behavioral assessments into its selection criteria. This raises questions, especially since the S&P Dow Jones Indices committee is looking for a replacement after the anticipated conclusion of Electronics Arts’ leveraged buyout set for 2027.
“Even well-established companies have been caught cheating indexes, but no one lambasts the index itself,” noted Kim Forrest, chief investment officer at Bork Capital Partners.
The selection of S&P 500 companies aims to provide a rational representation of the stock market, naturally inclining towards firms with rapidly increasing stock prices.
“Indices should mirror prevailing market conditions,” Blitzer remarked. “If tech comprises 38% of the market valuations—like today—the index should reflect that percentage.”
Interestingly, AppLovin is not the only company to face scrutiny soon after its S&P 500 inclusion. Super Micro Computer Co. was added in March 2024 but faced serious issues the following November, including the resignation of its auditor amid concerns regarding ethics. Both the Department of Justice and a critical short selling report investigated the company before its removal from the Nasdaq 100. Recently, its stock plummeted 8.7% following poor quarterly revenue guidance but rebounded by 2.6% the next day, while AppLovin gained 5.8%.
S&P Dow Jones Indices has opted not to comment on individual companies or impending changes to the index. Representatives from Super Micro Computer haven’t responded to multiple inquiries. An AppLovin spokesperson stated that the company doesn’t typically discuss regulatory issues and mentioned that it isn’t under investigation by state attorneys general.
In a follow-up statement, the AppLovin representative highlighted the company’s ongoing engagement with regulators and its commitment to consistency in public disclosures regarding business developments.
Today’s market dynamics suggest candidates for listings tend to exhibit more volatility and are often questioned by contrarian investors. Many stocks are pushed beyond their fundamental values, propelled by the rising interest in artificial intelligence and a record-breaking climb in indexes, with retail investors chasing after gains.
“In a vibrant bull market, even questionable stocks can gain traction significantly faster than usual,” remarked Steve Sosnick, chief strategist at Interactive Brokers. “Stock prices may rise to levels that call for consideration for inclusion, irrespective of dubious business practices.”
We saw similar patterns during the dot-com era in the late 1990s when companies like America Online, Global Crossing, and WorldCom were integrated into the S&P 500. After the bubble burst, numerous stocks were later excluded for failing to meet inclusion criteria. According to Bloomberg, between October 2000 and January 2002, ten companies were removed for this reason.
Regarding potential future removals, Blitzer suggested that while some might endure, many may not, leading to frantic attempts to find replacements. He noted that the inclusion committee has historically kept a list of 5-6 candidates ready for immediate action.
To preserve index stability, the S&P 500 selection committee typically excludes stocks that are losing traction. This approach aims to maintain constant sector weights and minimize turnover. Importantly, failing to meet eligibility doesn’t result in immediate removal; over 150 current S&P 500 stocks are below the typical inclusion size.
Signs indicate that the committee is particularly cautious with hot stocks. If a company qualifies but isn’t promptly included in the index, it usually reflects a need for deeper understanding of its operations. Many firms, including AppLovin and Coinbase, have experienced this process. For instance, Tesla debuted in September 2020 but didn’t land in the index until several months later. Carvana and Strategy Inc. are recent examples of companies that met the criteria yet were initially overlooked.
Mark Palmer, an analyst at Benchmark Equity Research, explained that companies preliminarily excluded due to volatility, governance, or index balance are still recognized as eligible. He noted that the omission of MSTR from the recent rebalance list aligns with this context; MSTR was previously known as MicroStrategy.
While S&P 500 inclusion is not an endorsement, it often serves as a significant milestone for companies, granting a certain level of validation — at least in the short term. Jake Seltz, a portfolio manager at Allspring Global Investments, remarked that it’s generally perceived as a vote of confidence when a stock is added to the index.
Typically, when companies are announced for the S&P 500, their stock prices increase, mainly because index-tracking funds need to acquire shares. However, these price jumps tend to be short-lived. Long-term performance hinges on the company’s ability to maintain solid fundamentals.
Inclusion usually encourages more favorable stock prices, according to Michael Sansoterra, chief investment officer at Sylvant Capital Management. He manages $2.9 billion in assets as of the end of June and emphasized that while the inclusion is positive, the underlying fundamentals must remain strong.
(Updated based on stock price fluctuations on Friday.)
