NEW YORK (CNN/Money) -
Depressing stock market fact of the day: For about $5 you can buy two slices of pizza and a soda (in New York at least), or you can purchase a share of one of 26 struggling companies in the S&P 500.
That's right, more than 5 percent of the companies in one of the market's most closely watched indexes are essentially penny stocks, shares that many mutual fund managers are prohibited from buying. It gets worse. Of those 26, twelve are not even expected to post a profit this year.
This dubious dozen includes former tech and telecom darlings like Lucent, Lucent spin-off Avaya, Ciena, and Gateway. But there are some non-tech names in this group as well, such as AMR, the parent of American Airlines, and McDermott International, an energy services firm.
As a result, it would not be a huge surprise to see several of these companies booted from the S&P 500. Usually, it would take a merger, major restructuring or bankruptcy for a company to get kicked out.
Getting rid of the stinkers
But another reason listed by Standard & Poor's for removing a stock is failure to meet current fundamental criteria for inclusion. While there are no official numerical guidelines for inclusion in the S&P, companies with market value below $3 billion and without steady profitability are typically not considered for the index.
And the folks at S&P have been increasingly willing to show laggards the door during this bear market. Handheld device maker Palm was removed from the index in August, just two years after joining the S&P 500. Communications chip company Vitesse Semiconductor, whose stock has plunged 90 percent this year, also was booted from the S&P in August.
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Neither company was acquired or went bankrupt. They just simply weren't as relevant in a market that has less of a focus on technology. Semiconductor company Conexant Systems and Internet consultant Sapient also were removed from the S&P 500 this year, even though neither was bought or filed for bankruptcy.
S&P recently published a study of low-priced stocks and concluded that stocks with a price less than $5 are more volatile, thinly traded and have higher transaction costs. But it singled out stocks with low market values as being specifically volatile.
David Blitzer, managing director and chairman of the index committee at Standard & Poor's, says that three analysts follow the 500 stocks constantly and update him about any that are in danger of being delisted. If the committee decides to remove a stock, the change could be announced in about two hours, and there is a list of about 15 candidates that are considered possible replacements.
Don't let the door hit you on the way out
With this in mind, what companies are at biggest risk of being removed? McDermott would not be a huge shock since its market value is now just $200 million, putting it in microcap status.
There are four troubled energy-trading firms in the index as well. Although all four are expected to be profitable this year, it seems tough to justify keeping Dynegy, Williams, Calpine and Mirant in the S&P 500. At least one of the four probably should go. None of these companies has a market value above $1 billion. Dynegy, with the lowest stock price and market value of the bunch, appears to be the most likely to get booted out, especially after reporting a $1.8 billion quarterly loss Wednesday.
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Looking at the tech and telecom firms, Avaya, software company Parametric Technology, communications chipmaker PMC-Sierra, and Novell all have market values below $1 billion.
Qwest and Sun Microsystems both have stock prices below $5 but appear safe for now since their market values are above $5 billion. Even Lucent, despite its myriad problems, probably won't be kicked out. It still has a market value of more than $3 billion. Plus, since its rival Nortel was removed when the S&P decided in July to get rid of companies not headquartered in the U.S., that makes it more likely Lucent will stick around.
However, it seems it will be tough to find worthy candidates to replace companies in the index. According to a screen on Multex Investor, there are only 14 U.S.-based companies with a market value of more than $3 billion and a float of at least 200 million shares that are not in the S&P 500 already. Companies like Warren Buffett's Berkshire Hathaway, newspaper publisher Washington Post and Internet company USA Interactive aren't likely candidates because they are not actively enough traded.
So who might pass all the S&P tests? Kraft has potential. The company has a market value of nearly $66 billion. Even though tobacco firm Philip Morris owns the majority of Kraft, there are still more than 250 million shares available to the public.
Biotech firm Genentech makes sense too. It's one of a handful of profitable biotech companies and it has a market value of $17.1 billion. Cox Communications is a contender as well, with a market value of $17.3 billion. Once Comcast's purchase of AT&T's cable division is complete, Cox will be the third-largest cable company in the U.S. And dare we say it, is Amazon.com worthy? It is actively traded, has a market value of $7 billion and is expected to be profitable this year and next.
But Blitzer says the index committee members often look for industries that are not well represented. That could open up the door for smaller companies like AutoNation, which is the largest independent auto dealer, with a market value of $3.2 billion. There are no auto dealers in the S&P 500. Likewise, there are no pharmacy benefit managers in the index, which means that a company like Caremark Rx, which has a market value of $4.2 billion, could be strongly considered.
It's unlikely that S&P will make massive changes to the index for fear of the disruptive effects that could have on the market. And Blitzer says he's always hesitant to remove a stock because he is worried that it will subsequently recover. But there will be more changes simply because there is more pressure from S&P 500 index fund managers to get rid of poorly performing stocks.
"Clearly, if we take a stock out at $2, and 6 months later it's trading at $10, we look silly and people who invest in the index will say, 'I missed a five-times gain'. But in talking to people who run index funds, the vast majority of managers say take the low-priced stocks out," Blitzer says.