The New Industry Standard

Why you may soon own Google.

With last week’s announcement of a $4 billion secondary public offering, Google continued its habit of surprising the market and delighting math dorks. The number of shares to be sold is 14,159,265—add a three plus a decimal point to the beginning of that number, and it comes out to π. (Perhaps next year, the company will start paying a quarterly dividend of 2.718 cents, the irrational number e).

Why would a company that already has nearly $3 billion in cash and generates massive profits undertake such an offering? When the Wall Street Journal polled a bunch of analysts, it came up with a couple of theories: Extra cash would allow it to invest in China and Russia (Goldman, Sachs analyst Anthony Noto), or take on Microsoft’s search technologies (Mary Meeker, dot-com survivor and Morgan Stanley analyst). In the Financial Times, Standard & Poor’s analyst Scott Kessler suggested Google might use the cash to buy the Internet telephone company Skype. In Monday’s New York Times,John Markoff dashed cold water on the acquisition meme and suggested Google might use the cash to develop new products like a smart phone, or a cheap wireless laptop. Or maybe it will use the cash to help support the rollout of an instant messaging service.

Of course, none of us knows, but I’d lay better than even odds that the main intent of this offering is to smooth the young stock’s passage into the august Standard & Poor’s 500 index. The S&P 500, composed of 500 large companies, is a tradable proxy for the stock market as a whole and for the economy at large. Through index funds (which buy every stock in the index), the increasingly popular exchange traded funds, and other vehicles, some $1.2 trillion in investments are currently tied to the S&P 500. That sum is equal to about 10.66 percent of the $11.25 trillion market capitalization of the S&P 500.

But as this column noted in 2002, the index is in a constant state of flux. When large companies merge or are acquired, or when their businesses falter significantly, they are removed from the index. Delta Airlines was dropped last week. And the victims of creative destruction get replaced by companies that have succeeded in the market or that are pioneering new, promising industries. As a result, the index can be something of a slave to investing fashion. Stocks appear on the committee’s radar screen only when they’ve risen a great deal, and they’re dropped after they’ve fallen hard. In the late 1990s, the S&P 500 added a host of high-flying technology companies at bubble valuations. And when changes occur, people who manage (or mimic) S&P 500 index funds have to sell the subtracted stocks and buy the stocks that have been added.

While the pace of change has clearly slowed since the height of the 1990s bubble, the S&P 500 is still a creature of the shifting fortunes of market sectors. As this list of recent changes shows, stocks in hot sectors like energy and real estate have been replacing technology, transport, and telecommunications stocks.

Could the S&P 500 could be on the verge of buying high again with Google? “We’re obviously aware of the stock, and beyond that we really can’t comment,” said David Blitzer, chairman of the eight-person index committee, which meets monthly to evaluate changes. But on the face of it, it’s clear that Google is an ideal candidate for inclusion. In fact, with each passing week, its continued omission becomes more glaring.

Consider the criteria for inclusion—go here, and then click on “S&P U.S. Indices Methodology.” The minimum size for inclusion is a market capitalization of $4 billion. Google is worth about $77 billion. As of yesterday, only 30 U.S.-based companies that are traded on U.S. stock exchanges were worth more than $75 billion. All are in the S&P 500 except Google, biotech giant Genentech, and Warren Buffett’s Berkshire Hathaway.

There are good reasons why the latter two are excluded. “Genentech is more than 50 percent owned by Roche Holdings, and we have a rule that a company has to have at least half its shares available to the public,” said Blitzer. And because Berkshire Hathaway trades at $86,800 for a single share, the stock is simply too expensive to be included.

Google suffers from neither of these handicaps. It clearly has sufficient liquidity and more than 50 percent of its shares available to the public. Companies must demonstrate “financial viability, usually measured as four consecutive quarters of positive as-reported earnings.” Check. S&P requires that IPOs be “seasoned” for six to 12 months before being considered for addition to indices. As of Aug. 19, 2005—the day after Google announced the new offering—Google’s IPO was 1 year old. (A coincidence? I think not.)

You don’t have to understand algorithms to do the math here. At some point in the near future, Google will probably be added to the S&P 500. So, why would the potential for inclusion in the S&P 500 spur Google to issue new shares? Once S&P announces it’s adding a stock to the index, it sets off a frenzy. Within days, all the people who manage S&P 500 funds—none of whom owned the stock before—will have to rush out and buy Google.

The folks at Google—and their investment bankers—probably figured this out months ago. Now, if you were a smart company and you wanted your stock to trade cleanly and smoothly, you would try to make new supply available in advance of a projected announcement. And the one surefire way to ensure an adequate supply is to sell a big chunk in a secondary offering. Indeed, the offering promises to increase the supply of Class A shares by about 9 percent.

Certainly, this is all speculation. It could be that, as Wall Street analysts suggest, Google is stockpiling cash for a big acquisition. Or that it plans to branch off into related services. It’s even possible that founders Larry Page and Sergey Brin want to deploy the funds to invest in another world-beating product—like a space elevator.