THE NASDAQ COMPOSITE INDEX

APRIL 02, 2014

THE NASDAQ COMPOSITE INDEX

A FOURTEEN-YEAR RETROSPECTIVE

DAVID KREIN | Head of Research ? NASDAQ OMX Global Indexes JEFFREY W. SMITH | Managing Director ? NASDAQ OMX Economic Research

HIGHLIGHTS

The NASDAQ Composite continues to be a usefully distinct stock market metric that distinguishes itself from other broad indexes routinely covered in the financial media.

Although the NASDAQ Composite has crossed 4000 again, a level last achieved in 1999, the index composition and valuation have experienced dramatic changes during this 14-year period. The changes reflect trends that are NASDAQ-specific, but also reflect the macro forces impacting the broader economy and capital markets.

The current index has about half the components it did 14 years ago (4,715 in 1999 versus 2,472 at the end of 2013). The current components, though, are on average about twice the size as they were in 1999.

The majority of the securities (by index weight) that left the index since the end of 1999 did so as a result of merger and acquisition activity. The current index is still strongly oriented towards the information technology sector, as it has always been. Currently 46% of the index by

weight is classified as Info Tech. The extent of technology orientation, however, appears to be receding. Company valuations at the current index level are much more conservative than during the midst of the tech bubble of 1999/2000. About 20% of current index weight (710 stocks) is from IPOs that NASDAQ brought to market during the last 14 years.

JAN. 90 JAN. 94 JAN. 98 JAN. 02 JAN. 04 JAN. 06 JAN. 10 JAN. 14

INTRODUCTION

At the end of November 2013, the NASDAQ Composite Index reached the milestone level of 4000 for the second time. The first time the index crossed this level was during the final days of 1999. At that time, what in retrospect became known as the "Tech" or "Dot-com" bubble was well underway. By early March 2000 the Composite would go on to reach its all-time peak of 5049, after which it began a precipitous fall as the bubble burst. The following figure illustrates this bubble and the steady climb back to 4000:

NASDAQ COMPOSITE INDEX: 1990?2013

6000 5000 4000 3000 2000 1000

0

Well before the tech bubble, but certainly during it, the NASDAQ Composite gained a remarkable level of publicity. Then, as now, the daily performance of the Composite is routinely reported by the mainstream and financial press, along with that of the Dow-Jones Industrial Average (DJIA) and the S&P 500. The term "tech-heavy" is often used by reporters when mentioning "the NASDAQ."

Before reviewing the changes that have occurred over the last 14 years, it is useful to understand the details behind the construction of the NASDAQ Composite. The index simply represents the value of all stocks listed on The NASDAQ Stock Market. Included are all common stocks and common equivalents, such as American Depository Receipts (ADRs) and Ordinary Shares (both of which refer to shares of non-US issuers). Derivatives such as warrants, as well as funds such as Exchange-Traded Funds (ETFs) are excluded. This purely transparent and automated approach stands in stark contrast with the Dow-Jones Industrial Average and the S&P 500, the components of which are chosen by committee.

The NASDAQ Composite has been around since the launch of NASDAQ on February 5, 1971, when its value was set at 100. The index is market capitalization weighted, meaning that a given stock's weight in the index is proportional to its market cap. A stock's weight is not "float-

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adjusted," i.e., reduced to account for shares not available to trade by the investment community. (Specific index rules are in a methodology document available at indexes.docs/methodology_ COMP.pdf.)

The NASDAQ Composite should not be confused with another wellknown NASDAQ index, the NASDAQ-100. The latter is made up of the top 100 non-financial companies listed on NASDAQ. It began in 1985, and uses an adjusted market cap weighting method that ensures that no single component of the index carries too much weight. It is interesting to note that while the Composite receives the majority of the coverage in the financial press, the NASDAQ-100 is much more prominent in terms of having financial products tied to it. Indeed, the NASDAQ-100 is specifically designed and maintained to provide the basis for financial products. For example, one of the largest ETFs in the world, the PowerShares QQQ, is benchmarked to the NASDAQ-100. The NASDAQ-100 also has a wide array of futures, options, and other products tied to it. As with the Composite, the NASDAQ-100's components are not chosen by committee, but by a set of distinct eligibility criteria and rules-based methodology.

THE CHANGING NATURE OF THE COMPOSITE INDEX

From day-to-day, changes in the level of the NASDAQ Composite (or no change at all) are reflective of the changes in value of the component stocks. Observers can easily interpret the NASDAQ at 4000, then 4001, then 4010, and so on. This is because the components, over such short time periods, don't change very much, except for their prices.

However, over longer time periods such as the last 14 years, the component stocks do change in very significant ways. This means observers cannot easily interpret the significance of NASDAQ 4000 then versus NASDAQ 4000 now.

In fact, there are so many changes that have occurred in this 14year period that analyses from several perspectives are warranted and worthwhile.

COMPONENT COMPOSITIONS Table 1 shows the total number of index components at the end of 1999 and the end of 2013. Also shown are the total market cap of the components and the average market cap per component.

TABLE 1: COMPONENTS OF COMPOSITE INDEX

DEC 31, 1999

VALUE OF INDEX

4069

NUMBER OF COMPONENTS

4,715

TOTAL MARKET CAP ($B)

$5,453

AVG MARKET CAP ($MM)

$1,157

DEC 31, 2013 4177 2,472 $6,271 $2,537

RATIO 1.03 0.52 1.15 2.19

The striking conclusion of the table is that the current index has 48% fewer components as before, but these components are nearly 120% larger than before on average. Also worth noting, while the value of the index at the two points of comparison are about equal, the market capitalization is 15% higher. This change is due to increases in shares of the listed companies, not increases in prices.

The results of Table 1 reflect a national trend that extends beyond NASDAQ--a shrinking number of listed public companies. The following graph shows the number of common stocks listed on the three US listing venues: NASDAQ, NYSE, and NYSE MKT (formerly the American Stock Exchange). The graph illustrates a remarkably steady decline; the end result being that the number of listings is about half of what it was at the start of the 2000s. The causes of this trend and whether capital markets are better or worse off as a result is a fascinating question beyond the scope of this paper.

NUMBER OF LISTED U.S. COMMON STOCKS

LISTING VENUES: NASDAQ, NYSE, NYSE MKT 9000

8000

7000

6000

5000

4000

NUMBER OF STOCKS AT MID-YEAR 2000 2002 2004 2006 2008 2010 2012 2014

Table 2 shows the identity and market capitalizations of the top ten components.

TABLE 2: TOP 10 COMPONENTS THEN AND NOW

12/31/99

STOCK

MKT CAP ($BLNS)

MICROSOFT

$606

CISCO

$360

QUALCOMM

$332

INTEL

$277

WORLDCOM

$228

ORACLE

$151

DELL

$132

SUN MICROSYSTEMS $117

YAHOO

$103

JDS UNIPHASE

$75

12/31/13

STOCK

MKT CAP ($BLNS)

APPLE

$505

MICROSOFT

$312

GOOGLE

$310

AMAZON

$182

INTEL

$129

QUALCOMM

$125

CISCO

$120

GILEAD SCIENCES

$115

COMCAST

$111

FACEBOOK

$102

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The top four companies of 1999 still appear in 2013, but their aggregate market value is 44% of what it was then. The fifth company, WorldCom, went bankrupt in 2002. The combined reduction in market cap of these five securities is about $1.1 trillion, which is nearly 20% of NASDAQ's total market cap in 1999. In fact, exclusive of these five stocks, the average market cap per stock rose from $774 million to $2.26 billion, an increase of 192%.

The table shows why the index is strongly associated with the technology sector, both in 1999 and currently. It is interesting to see, however, in the current top 10 list the emergence of marquee companies not in the Information Technology sector: Amazon in retailing, Gilead in biotech, and Comcast in media. Also noteworthy is the presence of the largest social networking company, Facebook. Overall, while some names have changed, there can be no doubt that the NASDAQ Composite index's top components have historically featured companies that are known for innovation and growth.

NATURE OF DELETIONS

As the preceding tables illustrate, there has been substantial change in the composition of the index as well as a reduction of about onehalf in the number of components from 2000. What has happened to the companies present in 1999 but no longer in the index?

TABLE 3: DISPOSITION OF INDEX COMPONENTS PRESENT AT END OF 1999

NUMBER

TOTAL MKT CAP AT END OF 1999 ($T)

ALL

4,715

$5.43

VETERANS TO END OF 2013 1023 (22%)

$2.89 (53%)

DELETED BY END OF 2013

3692 (78%)

$2.57 (47%)

About 53% of the market value of the index, drawn from 1,023 issues, has lasted 14 years to continue to be in the index. The other half of market value, made up of almost 3,700 issues, representing 78% of the stocks on NASDAQ at the time, have left the index. Given the numbers, it is clear that the deletions tended to be smaller on average than the veterans ($696 million versus $2.82 billion).

NASDAQ tracks the cause behind these deletions, summarized as follows:

TABLE 4: REASON FOR NASDAQ DELETIONS

NO. STOCKS PCT MKT CAP

MERGER/ACQUISITION

1786

53.9%

REGULATORY NON-COMPLIANCE

674

17.4%

VOLUNTARY DELISTING

812

25.0%

MOVED TO OTC

109

1.3%

OTHER

311

2.4%

TOTAL

3692

100.0%

Most interesting to note is that 54% of the stocks by market cap (and 46% by number of deleted stocks) were removed due to merger and acquisition activity. This runs counter to the popular belief that in the collapse of the tech bubble most of the NASDAQ stocks were "dot-coms" and deleted due to bankruptcy. This is, in fact, not the case at all.

This M&A activity is consistent with a general theme of a market of fewer but larger public companies. Within the M&A category there are several possible outcomes:

a. Both acquirer and target are listed on NASDAQ and the combined entity remains listed on NASDAQ. This would reduce the number of NASDAQ-listed companies, but would not result in a reduction in the market cap of listings. (Presumably the market cap of the combined entity is roughly the sum of the two companies individually.)

b. E ither the acquirer or target is listed on NASDAQ, and the combined entity leaves NASDAQ. This would reduce the number of NASDAQlisted companies and would reduce the market cap of listings.

More than 17% of deletions (in terms of value) was a result of companies failing to meet listing standards as a result of declining business prospects, including bankruptcy. The largest company in this category was telecommunications firm WorldCom. This company's demise, along with that of NYSE-listed Enron, was a key trigger behind the Sarbanes-Oxley reforms of 2002 mandating tighter financial management and reporting for public companies. The failure of many of the dot-coms was a trigger for another regulatory reform--the Global Securities Analyst Settlement of 2003. This settlement sought to ensure that research from securities analysts was not conflicted by investment banking relationships.

A comparatively small amount of lost market cap was due to companies delisting for reasons other than being forced to delist. An example of this case concerns ADR programs that were cancelled by the (foreign) issuer. Another small group of companies left NASDAQ but continued to trade on the Over-the-Counter (OTC) market. While not representing an outright cessation of trading, this demotion to OTC trading was typically the result of an inability to meet listing standards.

ADDITIONS TO INDEX

As a flip side to the deletions, analysis of additions to the NASDAQ Composite index can also be considered. The following table provides this information.

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TABLE 5: SOURCES OF NASDAQ COMPONENTS SINCE 1999 AS OF END OF 2013

PCT OF MKT CAP NUMBER END OF 2013

VETERANS

1023

61.2%

IPOS

710

19.8%

SWITCHES FROM OTHER EXCHANGES

147

10.8%

UPGRADES FROM OTC

298

1.7%

OTHER

294

6.5%

TOTAL

2472

100.0%

The majority of the current value of the Composite is from companies that were in the index in 1999. These 1,023 veterans, which are 61% of the current index value and 41% by number of stocks, have an average size of $3.8 billion, while in 1999 their average value was $2.8 billion.

It is interesting to note how these figures look without the top four of 1999: Microsoft, Intel, Cisco, and Qualcomm. In 1999, the 1,019 surviving stocks had a market cap of $1.3 trillion; those same 1,019 veterans had a market cap of $3.2 trillion at the end of 2013, an increase of 140% (versus 33% when the top four are included).

The largest source of additions has been IPOs. Over the last 14 years NASDAQ has brought to market 710 stocks that are still listed on NASDAQ today. Perhaps the most prominent among them are Google and Facebook, but there are many other easily recognizable names.

Transfers from the NYSE and NYSE MKT totaled 147 and account for about 11% of market value. Most of these transfers have occurred from 2008 forward. Some of the larger switches from NYSE are Twenty-First Century Fox (formerly News Corp), Texas Instruments, and Automatic Data Processing (ADP). Note the large average size of these transfers. The size and number of switchers illustrate a competitive dimension to listings, with moves going in both directions.

A comparatively small group of additions have joined the NASDAQ Composite by upgrading from the OTC world. Finally, some companies have joined by other means, typically through some type of corporate action such as a spinoff. A recent example is the listing of Kraft Foods, which was spun off of Mondelez (itself originally known as Kraft). Another example is the parent company of NASDAQ itself, the NASDAQ OMX Group, which was carved out of the old National Association of Securities Dealers (NASD), a regulatory body, and never came to market as an IPO.

CHANGING PROFILE

The large number of changes in component stocks over time has begun to shift the profile of the Composite in meaningful ways.

COMPANY AGE

NASDAQ has always been thought of as the home of younger companies. In fact, it also contains a number of companies dating to the 19th century, many of which are community banks (among the oldest is Hingham Institution for Savings, founded in 1834). On a market-cap weighted basis, however, NASDAQ tends to be a market of younger, growth-oriented companies. Consider the "median marketcap weighted age," defined such that half the index market cap is made up of companies older, and half younger, than this median age. For this analysis, age is defined as time from incorporation, not the time from IPO or initial listing. For, example, Facebook was incorporated in 2004 but did not have its IPO until 2012. As of the end of 2013, therefore, its age was nine years.

TABLE 6: MARKET CAP MEDIAN AGE OF NASDAQ COMPANIES

DEC 31, 1999

DEC 31, 2013

15.1 YEARS

25.0 YEARS

All else equal, a mature steady-state capital market would be expected to have a natural cycle of company births and deaths leading to a constant median age. On NASDAQ, however, in 14 years, the median age went up 10 years, indicating substantial maturation.

The age of veterans and new additions as of the end of 2013 is shown in the next table.

TABLE 7: MARKET CAP MEDIAN AGE OF COMPOSITE COMPONENTS AS OF END OF 2013

MEDIAN AGE (YEARS)

VETERANS

36.9

IPOS

13.9

SWITCHERS (EXCHANGE + OTC)

16.9

OTHER

14.2

Not surprisingly, the veterans are the oldest group, their age being exactly 14 years older than it was in 1999. Even at 37 years, however, the veterans are still young companies. Also not surprising is the low median age of the IPOs. The switchers are perhaps surprisingly young. This finding suggests that younger companies are the most likely to switch to NASDAQ. Interpreting the age of the "Other" group is difficult, since the event that caused the company to be listed in the first place may be closely tied to its birth (for example, a coincident spin-off and NASDAQ listing).

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In all cases, the additions to the NASDAQ Composite during the last 14 years have been younger than the incumbents, keeping the median age lower than it otherwise would have been under natural aging.

COMPANY INDUSTRY

As mentioned previously, the NASDAQ Composite Index is generally associated with various High-Technology sectors, Information Technology in particular. In comparing the industry orientation of NASDAQ between now and 14 years ago, the only available measure of industry is the Standard Industry Classification (SIC) system of the US government. With these definitions, the top SIC industries (at the fourdigit level) now and then are shown in the following table.

TABLE 8: TOP SIC INDUSTRIES LISTED ON NASDAQ

End of 1999

SIC INDUSTRY

PCT OF MKT CAP

PREPACKAGED SOFTWARE

23%

SEMICONDUCTORS

10%

COMPUTER PERIPHERALS

8%

TELECOM

7%

ELECTRONIC COMPUTERS

5%

COMPUTER SYSTEMS 3%

TELEPHONE APPARATUS

3%

End of 2013

SIC INDUSTRY

PCT OF MKT CAP

PREPACKAGED SOFTWARE

10%

ELECTRONIC COMPUTERS

9%

SEMICONDUCTORS

9%

INFORMATION RETRIEVAL

6%

BIOLOGICAL PRODUCTS

6%

CABLE TELEVISION

5%

PHARMACEUTICAL

4%

ALL INFO TECH

57%

ALL INFO TECH

38%

Figures in the Table 8 provide clear justification for NASDAQ's tech reputation. However, comparing the two periods suggests that the current NASDAQ is less tech heavy than in 1999. The sum of all SIC industries that may be considered "Information Technology" indicates a decline in terms of percentage of market cap from 57% to 38%.

Again, one can consider the impact of deletions and additions on the evolution of NASDAQ's industry orientation. Instead of using the SIC system, it is preferable to use a proprietary classification system that is more up-to-date and better designed for the use of investors. One such system is the Global Industry Classification Standard (GICS) system offered by Standard and Poor's. The following table shows the sector breakdown of current components of the NASDAQ Composite.

TABLE 9: GICS SECTOR OF COMPOSITE COMPONENTS

PCT MARKET CAP

GICS SECTOR

VETERANS IPOS SWITCHES OTHERS

INFORMATION TECHNOLOGY 50%

56% 28% 11%

CONSUMER DISCRETIONARY 16%

15% 33% 47%

HEALTH CARE

17%

14%

5%

13%

FINANCIALS

7%

5%

9%

11%

INDUSTRIALS

5%

5%

3%

7%

CONSUMER STAPLES

3%

1%

9%

8%

TELECOMMUNICATION SERVICES

0%

0%

10%

1%

ENERGY

0%

3%

2%

2%

MATERIALS

1%

1%

1%

1%

UTILITIES

0%

0%

0%

0%

Analysis of GICS sectors again confirms the strong IT orientation of the NASDAQ Composite, with about half of the NASDAQ Composite's market cap in the GICS IT Sector. The IPO additions to the Composite have a sector profile very similar to that of the veterans. Quite interestingly, however, is the fact that the other additions to the NASDAQ Composite do not have the same level of technology orientation. The net result is that the current the NASDAQ Composite has evolved with a lower technology tilt than before.

VALUATION

A hallmark of the 1990s bubble was the sky-high valuation levels of NASDAQ-listed companies. The following table shows price/earnings ratios then and now for a selection of marquee companies.

TABLE 10: PRICE/EARNINGS RATIOS OF SELECTED COMPANIES

STOCK MICROSOFT

INTEL CISCO APPLE QUALCOMM YAHOO

END OF 1999 73 35 166 37 224 787

END OF 2013 13 14 13 14 19 35

The 2013 values of the P/E ratio are much lower relative to their 1999 values. Many components of the NASDAQ Composite in 1999 had no P/E ratio, owing to a lack of earnings.

Using its proprietary analytics, Bloomberg provides a number of valuation metrics for indexes as a whole. Here is a set of such metrics for the NASDAQ Composite index.

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