How Leaving the S&P 500 Affects Urban Outfitters (URBN)

Apparel chain Urban Outfitters, Inc. (URBN) is being removed from the Standard & Poor's 500 Index, and the stock sank more than 3 percent in the wake of this news. S&P's new guidelines for membership of its flagship index require a market cap of $6.1 billion, a 15 percent increase over the prior year. Urban Outfitters has a market cap of $2.67 billion as of March 2017 after sliding nearly 50 percent over the trailing 24 months.

Index inclusion can be an important driver of demand for some stocks. Many exchange-traded funds (ETFs), mutual funds and managed vehicles track indexes, so these portfolios are forced to purchase the shares of any applicable index constituents. Conversely, these funds are no longer required to hold stocks that are removed from their stated index, which could have negative effects on the demand for shares. The S&P 500 is the most tracked index of U.S. equities, so the magnitude of the index effect could potentially be very large for joining or leaving the ranks. (See also: How Do Indexes Determine Which Stocks Are Removed or Added to Them?)

There have been numerous attempts to study this phenomenon, but there is mixed evidence on the magnitude or the index effect. Comprehensive studies for recent years suggest that removal from the S&P 500 has a very limited impact on short-term pricing, and long-term pricing studies are complicated by other factors that affect stock prices, such as earnings reports, qualitative news or industry trends. Portfolio managers of index-tracking funds generally have some wiggle room regarding the timing of rebalancing, so it is unlikely that there will be a very short time span in which every Urban Outfitters share is unloaded. It also appears that potential incoming and outgoing constituents are identified far in advance of official confirmation, which influences the market prices. Market cap weighting also plays a role, as stocks near the cusp of inclusion tend to make up a very small portion of the S&P 500. (See also: Computing Indexes.)

Falling out of the S&P 500 cannot be considered a good thing in this context, but this development is a symptom of Urban Outfitters' struggles rather than the result of a major catalyst. Consumer trends enabled by Amazon.com, Inc. (AMZN) have wreaked havoc on the traditional retail industry by intensifying price competition, squeezing margins and forcefully reducing the prevalence of brick-and-mortar retailers. Urban Outfitters has not been spared any hardship, but the company has maneuvered relatively well to manage the transition. Nearly one-third of the company's sales are made online, which is high among large specialty apparel retailers. Urban Outfitters has also focused on broadening its offering by adding non-apparel categories. (See also: Has Urban Outfitters Lost Its Way?)

Urban Outfitters has nonetheless reported slowing revenue growth, margin contraction and uneven earnings growth. The company's outlook is not much better, with analysts expecting 3 percent revenue growth in the coming years. (See also: Urban Outfitters Wobbles After a Mixed Q4 Report.)

The outlook on earnings growth is more bullish, with a five-year analyst consensus CAGR of 13 percent. Urban Outfitters pays no dividend, so holders are implicitly anticipating appreciation due to fundamental growth. It is difficult to construct a bull narrative based on Urban Outfitters' fundamentals as of March 2017, although the stock does compare favorably to other apparel retailers struggling under the same circumstances. (See also: What Makes Urban Outfitters a Strong Sell?)

Looking at a battery of relative valuation metrics, Urban Outfitters is relatively inexpensive compared with its industry peers. The stock's valuation multiples are slightly below average nearly across the board, with PEG ratio representing an especially attractive metric. Assuming five-year analyst earnings growth forecasts are reliable, then Urban Outfitters has an excellent growth-adjusted earnings multiple. Considering the company's efforts to position itself well for the continued growth of e-commerce, this could be an opportunity for investors seeking exposure to the apparel retail space. Investors should not be dissuaded by Urban Outfitters' exit from the S&P 500 Index.