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The S&P 500 Welcomes Lululemon: Is This a Game-Changer for the Stock?

Motley Fool - Wed Oct 18, 2023

In October, tech giant Microsoft completed its acquisition of video game publisher Activision Blizzard. For its part, Activision Blizzard was a constituent of the S&P 500 -- an index of 500 of the largest, most profitable U.S.-based companies.

Since Activision Blizzard is no longer independent, a new company needed to take its place in the index. And that company is athletic apparel company Lululemon Athletica(NASDAQ: LULU).

Lululemon stock soared to a 52-week high following this announcement. Some believe that an old stock market theory called the "S&P 500 Inclusion Effect" is delivering lucrative gains. However, in this article I'll explain why this isn't the case and how this can impact returns for Lululemon investors.

The end of a prevalent investor perception

Years ago, Wall Street noticed something: Whenever the S&P 500 added a new company to the index, that new company usually outperformed the market average. This was dubbed the S&P 500 Inclusion Effect. And it's real -- or at least it used to be.

According to a 2021 report by S&P Global, new stocks in the S&P 500 beat the market by an average of 8.32% from 1995 through 1999. The analysts measured the performance only between the announcement date and the effective date.

Between the announcement date and the effective date, S&P 500 index funds buy shares of the new additions to accurately reflect the index. And this buying pressure from index funds drove up stock prices in the past.

However, S&P Global's research also showed that the inclusion effect entirely vanished from 2011 through 2021 -- there's no longer any routine outperformance.

Here's the reason: There's more liquidity in the stock market than in times past. Therefore, stocks can handle the added buying pressure from index funds because investors buy and sell stocks with greater frequency than ever.

What's really happening with Lululemon stock

With Lululemon, I'm going to advocate that long-term investors focus on its business fundamentals and the valuation of its stock. Being added to the S&P 500 doesn't change the game in any way.

Some may cry foul. For Lululemon, its membership in the S&P 500 was announced on Oct. 13 and its effective date is Oct. 18. And it's already outperforming the market by a wide margin. Doesn't this mean the inclusion effect is still working?

Not so fast. Electrical company Hubbell is also being added to the S&P 500. But it hasn't jumped like Lululemon. What gives?

Lululemon is quantifiably a more volatile stock than Hubbell. Volatility is measured with a metric called a beta. And the chart below shows that Lululemon's beta is more than twice that of Hubbell.

LULU Beta (1Y) Chart

LULU Beta (1Y) data by YCharts

In other words, Lululemon stock has crushed the market since it was announced that it was joining the S&P 500. But this demonstrates its above-average volatility, not the S&P Inclusion Effect. That might sound trivial. But it's a crucial distinction for long-term investors to make, I assure you.

What's ahead for Lululemon stock?

Over the last 10 years, Lululemon's trailing-12-month revenue has skyrocketed by nearly 500% and sits at $8.8 billion as of this writing. In short, it's been one of the greatest growth stocks to own.

That said, Lululemon stock has been on a volatile ride, dropping at least 40% from its high on four different occasions -- once every couple of years.

LULU Chart

LULU data by YCharts

Investors often sell stocks for the wrong reasons. And they're particularly prone to selling when stocks are down -- the worst time. I'd wager that many investors sold Lululemon stock during one of its many volatile drops. And in so doing, they missed out on market-crushing upside.

Looking ahead, Lululemon still believes it has ample opportunity for growth. Its athletic apparel is still popular, especially among the yoga community. But the company is expanding in other categories, including menswear and even more casual women's clothing. Moreover, international expansion is low-hanging fruit.

For a variety of reasons, Lululemon believes it can generate $12.5 billion in full-year 2026 revenue. Not only is it ahead of schedule, but management believes its profits will grow even faster than sales, which has historically been the case. And profit growth will drive long-term returns for Lululemon shareholders.

Things are looking good for Lululemon shareholders in the coming years. But here's the thing: The stock will likely still be as volatile as it's been up until now. And investors can't be shaken out every time shares fall.

For those who sell every time the stock goes down, poor returns can be expected. Therefore, Lululemon shareholders will need to keep their eyes on the business, especially between now and 2026. As long as it's making progress toward its business goals, this will likely be a good stock to own.

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Jon Quast has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Lululemon Athletica, Microsoft, and S&P Global. The Motley Fool has a disclosure policy.

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