The S&P 500 Has Dropped Etsy. 3 Reasons You Shouldn't.

The S&P 500 recently completed its latest quarterly rebalancing, a move to ensure the benchmark serves its purpose -- showcasing the performance of the top 500 companies driving today's economy. This generally involves the removal of certain members and the addition of new ones. In the latest reshuffle, the S&P 500 dropped an e-commerce stock that skyrocketed during early pandemic days.

I'm talking about Etsy (NASDAQ: ETSY), an online marketplace connecting the makers of handmade goods with buyers. Shoppers flocked to the platform during lockdowns, but in recent times Etsy has faced the headwinds of greater competition with physical stores and pressure on the consumer's wallet. That's weighed on growth and stock performance -- the shares have declined 36% this year.

But before you consider following in the footsteps of the S&P 500 and dropping Etsy, it's important to remember the move doesn't reflect a loss of faith in the company. Instead, it's a reflection of where Etsy stands in terms of size. The company's market cap has dropped from a high of more than $35 billion to about $5.8 billion today, making it more suitable for the S&P SmallCap 600 -- the company entered this benchmark as it exited the S&P 500.

Now let's consider three reasons you should buy this smaller yet still promising player.

Image source: Getty Images.

1. Consumers still love Etsy

Higher inflation hurt consumers' buying power, pushing them to prioritize essentials and drop many of their non-essential purchases. This has weighed on buyer growth at Etsy, but it's important to remember that the company still has impressive levels of habitual buyers and active buyers -- and its retention rate remains strong.

Habitual buyers are those who have bought on at least six days and spent at least $200 over the past 12 months, while active buyers have made at least one purchase over the past 12 months. In the most recent quarter, Etsy's habitual buyers stood at 6.9 million, active buyers reached 91.5 million, and the company acquired 12 million new and reactivated buyers. The company's retention rate of active buyers remains above pre-pandemic levels, and the retention rate of habitual buyers improved year over year.

On top of this, Etsy is launching a paid program with benefits -- Etsy Insider -- in beta to a small audience this fall, a move that could drive loyalty.

This solid connection with buyers should help boost growth at Etsy as the consumer's spending power strengthens -- and lead to earnings gains over time.

2. A smart business model

Etsy has a capital light business model, meaning it doesn't have to make major capital investments in, for example, transport and storage of goods. The company offers sellers a platform to sell their products -- but these sellers take care of all logistics, from stocking their items to shipping them out to customers.

This means Etsy can focus its investments in areas to promote sales, like marketing and using artificial intelligence (AI) to make its platform more efficient for sellers and buyers. Right now, it's working on AI for conversational search, fraud detection, and uses in many other areas.

Etsy's capital light business model, by limiting expenses, supports a healthy balance sheet. The company has more than $1 billion in cash -- and it's able to transform 90% of adjusted EBITDA into free cash flow on a trailing 12-month basis from quarter to quarter.

This business model has helped Etsy maintain strength during tough times and should help the company grow more quickly as the economic environment improves.

3. Etsy is cheap right now

Today, Etsy trades for about 11x forward earnings estimates, down from more than 17 earlier this year. This looks like a bargain considering the two points I've mentioned above as well as Etsy's investments in growth today -- such as its new loyalty program -- and its ability to delivery profitability. In the quarter, Etsy's adjusted EBITDA of about $179 million was 28% ahead of the company's expectations.

Etsy may take some time to truly rebound and advance, as it also will take time for the consumer's buying power to improve. But that's OK. The best way to invest is for the long term, and this means getting in on a stock at an interesting price and possibly benefiting as it progresses through its growth story. And this is why now is a great time to buy -- or hold onto, if you're already a shareholder -- Etsy and set yourself up for a potential win over the long term.

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Adria Cimino has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Etsy. The Motley Fool has a disclosure policy.