Investing legend Rob Arnott's $147 billion firm says stocks kicked out of the S&P 500 have huge upside — and is betting on these 7 recent dropouts trading at bargain prices

• Just because a stock gets removed from an index doesn't mean it's a bad investment.
• Rob Arnott's firm is betting on index deletions to deliver huge upside at low entry prices.
• Here are 7 index rejects that have rebound potential.

When a stock gets dropped from a major index like the S&P 500, index fund managers scramble to exit their holdings.

But legendary investor and Research Affiliates founder and chairman Rob Arnott does the opposite — instead, he buys up index rejects at a deep discount.

It seems counterintuitive to bet on stocks that have performed so poorly that they've gotten kicked out of a major index, but there's a method to the madness.

Stocks can be delisted from an index for reasons such as insufficient market capitalization, bankruptcy, and noncompliance with exchange rules. Deletions often end up in the Russell 2000 after falling out of the S&P 500 or Russell 1000 index. But that doesn't mean they're bad investments, according to Research Affiliates.

Arnott and Forrest Henslee, the vice president of research at Research Affiliates, found that in the year leading up to removal, index deletions typically lag the market by more than half. But after being deleted, it's a whole other story: in the five years after removal, index deletions outperform the S&P 500 by 28%, or 5% annually.

In August, Research Affiliates launched the Research Affiliates Deletions Index (NIXT), which creates an equally weighted portfolio of companies deleted from a top 500 and top 1000 index. Stocks are held for a five-year period with annual rebalancing.

A cheap way to lean into small and mid-cap value

Investing in deletions is a great way to get exposure to stocks outside the large-cap universe. Deletions are priced cheaply, and usually, if they've fallen out of S&P 500 territory, they have relatively small market caps.

According to Arnott and Henslee, index deletions are priced at an extreme discount — roughly half of the market multiple — making it easier for these companies to appreciate in price. Meanwhile, new index additions are priced at roughly twice the market multiple, creating a widespread. These deletions' low valuations might not be aligned with their intrinsic value, meaning investors gain when valuations normalize.

Additionally, when a stock is removed from an index, index fund managers need to rebalance their portfolios, resulting in a rapid sell-off of the deleted stocks. High levels of selling activity depress the stock prices of index deletions even further, creating an even bigger opportunity for these stocks to bounce back, according to Arnott and Henslee.

This investing strategy is especially advantageous in the current growth-dominated market. Big Tech stocks have carried the S&P 500 to record high after record high, but "deletions may well add abnormal upside to a portfolio when the current growth-dominated bubble (and, yes, it is a bubble) starts to deflate," Arnott and Henslee wrote in a recent report.

As Q3 earnings season continues, the market has come to be disproportionately impacted by the results of a few of the S&P 500's biggest companies. Nvidia earnings releases have become a major economic event almost akin to a FOMC meeting, in Henslee's opinion.

"If you buy a company that's highly valued, that company needs to perform spectacularly to keep up with its high valuation," Henslee told Business Insider in an interview.

But for deletions, the opposite is true.

"These companies are not overvalued, and they're actually priced for the worst," Henslee said of deletions. "All they need to do is outperform bleak expectations to provide a good return on your capital," he added.

7 S&P 500 dropouts to monitor

For index-beating returns, you can't invest blindly in any stock that's been kicked out of an index, though.

"Some of these companies do rebound, some don't," Henslee said. "Your winners need to make up for your losers."

Research Affiliates screens index deletions based on quality to avoid so-called falling knives, or stocks that are plummeting in price with no sign of a turnaround. But in the aggregate, a portfolio of deletions should outperform the S&P 500 for at least five years after being removed from the index.

Listed below are some of the top constituents of Research Affiliates' deletions index that have recently been removed from major indexes.