Typically, when a stock gets removed from one of the major indexes, such as the S&P 500 (^GSPC -1.11%), it loses a lot of its appeal, especially to professional investors on Wall Street. As exchange-traded funds (ETFs) and mutual funds sell the deleted stocks to rebalance their tracking portfolios, the once-promising businesses tend to plummet into value stock territory.
However, data from Research Affiliates shows that this may be the best time for individual investors to consider buying the beleaguered stocks -- when sentiment toward the stocks is at its lowest levels. Research Affiliates found that from 1991 to 2019, stocks deleted from the S&P 500, Nasdaq-100, and Russell 2000 went on to outperform their indexes by five percentage points annually over the next five years.
Two stocks that look primed to keep this historical trend going are hand-crafted goods exchange Etsy (ETSY -2.10%) and cereal behemoth WK Kellogg (KLG -1.81%). Whereas the S&P 500 removed Etsy from its index earlier this year as Etsy's market capitalization became too small, Kellogg spun off from its parent company, Kellanova, in 2023, leaving it too diminutive to stay in the index.
Following their departures from the index -- and subsequently becoming castaways -- I believe both stocks now trade at a once-in-a-decade valuation. Here's why the two businesses look like brilliant buy-and-hold investments for individual investors willing to hold for at least five years.
1. Etsy
Generating 82% of its revenue from sellers that consider themselves a "business of one," Etsy's homemade goods bring a human touch that its mega-retailing peers can't match. However, after seeing sales rise by more than 100% during the pandemic, Etsy's growth slowed to single digits over the past year, creating one of the wildest boom-and-bust cycles in recent history.
With consumers in the United States reining in discretionary goods spending (on a percentage basis) for each of the last 11 quarters, Etsy's stock has plummeted 81% from its all-time highs.
Data source: Etsy's Q3 earnings presentation.
On the heels of this drop, Etsy recently traded at just 11 times free cash flow (FCF), near all-time lows. Even accounting for stock-based compensation, the company only trades at 15 times FCF.
To put this price-to-FCF ratio in perspective, a reverse discounted cash flow (DCF) calculator would show that Etsy merely needs to grow FCF by 4% annually over the next 10 years to be an outperforming investment proposition. What's interesting about this figure is that Etsy grew its revenue by 4% in its most recent quarter, despite operating in a very challenging consumer discretionary environment.
The minimal growth needed to clear this low bar provided by the DCF model should be achievable for Etsy, especially considering the success it saw in bringing customers onto its mobile app in the third quarter. During Q3, the company added 3 million incremental app downloads from a new signed-out listing page prompt on its mobile website, compared to its 91 million active users.
Buyers who purchase items through Etsy's mobile app have a 40% higher lifetime value, making this ongoing shift very important to its prospects. In Etsy's case, customer lifetime value equals the present value of all the future revenue it would generate from a given user. With less than half of Etsy's gross merchandise sales flowing through its app, there is ample room for continued growth in this area.
And the cherry on top for investors? Since the company is already a cash cow with a FCF margin of 22%, it has immense funding to use for buying back shares at its once-in-a-decade valuation. Having already lowered its share count by 4% annually over the last four years, Etsy should continue hoovering up its shares at this discounted price, making it a compelling turnaround story.
2. WK Kellogg
WK Kellogg is home to well-known brands like Frosted Flakes, Special K, Froot Loops, Raisin Bran, Frosted Mini Wheats, and Rice Krispies. Despite these famous brands, the market cast Kellogg aside following its spinoff from Kellanova in 2023 and subsequent departure from the S&P 500. While a pure-play cereal company may not have the average investor thinking of market-beating potential, this somewhat unloved status is what makes WK Kellogg interesting.
Though Kellogg's share price is slightly higher than where it debuted a little over a year ago, the stock remains 25% below its highs. Following this drop, the company may be available at what looks like a once-in-a-decade valuation -- deeply discounted compared to its cereal peers, Post and General Mills.
Combined, the three companies account for roughly 75% of cereal sales in the U.S. and hold similar market shares, yet Kellogg trades at a mere 7 times next years' earnings before interest, taxes, depreciation, and amortization (EBITDA).
KLG GIS POST EV to EBITDA (Forward) and EBITDA Margin data by YCharts
Though this enterprise value (EV)-to-EBITDA ratio of 7 is cheap on its own merit, it could prove to be ridiculously discounted, considering that Kellogg is yet to fire on all cylinders in terms of its EBITDA margin. Guiding for mid-teens EBITDA margins by 2026 after the company spends $500 million to modernize its supply chain and shore up its efficiencies as a stand-alone business, Kellogg would be vastly undervalued if it delivers on this promise.
Raising its adjusted EBITDA growth guidance for 2024 to 5% to 6% from 3% to 5% while increasing its adjusted EBITDA margin to 10.5% through the first three quarters of 2024, Kellogg is showing signs of early progress for investors.
Best yet for investors, Kellogg rewards its shareholders with a generous 3.7% dividend yield as it works to forge its independence as a stand-alone unit on the publicly traded markets.
Ultimately, Kellogg's growth potential isn't going to blow your hair back in excitement, with Statista projecting the industry to grow by 2% annually through 2029. However, trading at a valuation that has Kellogg essentially priced for a slow death, mere survival for the company could produce market-beating returns -- and I can't imagine a world without Frosted Flakes in it anytime soon.
