Get Ready For the New Russell Indexes

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It’s that time of year again. The time when small cap investors can speculate as to which stocks will stay and which stocks will go. I wouldn’t go so far as to say this is the time when we separate the winners from the losers – but that’s not too far off.

This is the time when astute investors may see a nice pop in certain stocks, and other investors will shed a tear as their stock gets cut. It’s sort of like the ‘spring training’ of stock indices – at least at Russell.

If you haven’t guessed it by now, I’m talking about this week’s annual reconstitution of the Russell indexes 

In addition to the Russell 2000, all of the group’s other indexes will also be rebalanced. These include the Russell 3000 Index, the Russell 1000 Index, and the Russell Microcap Index.

***Although the “Russell Reconstitution” hasn’t officially been named a holiday just yet, smart investors can still expect to receive a sizable gift in the form of higher trading volume this Friday. In 2009, the day of the Russell rebalance was the biggest trading volume day of the year. So far this year volume has been particularly light, and an increase in volume could mean above average percentage point swings for individual small cap stocks.

A preliminary listing of the additions and deletions to the index will come out this Friday, on June 11. The final line-up will be published on June 25^th.

What that means for you is big trading volume and even bigger opportunity, as the reconstitution comes with the reconstitution guessing game.

Who’s in, who’s out, and how can we make a dime off of getting it right. I’ll discuss the profit opportunity in a second, first let’s cover the basics.

***Russell starts this annual process by breaking down the largest 4,000 U.S. companies by market cap. These companies are then broken into smaller subsets as required to fit in the respective indexes. All together, the Russell U.S. indexes cover nearly 100 percent of the U.S. equity market.

 The conditions for joining the expansive ranks of the Russell’s indexes are straightforward, click here for the full criteria. There are four main criteria:

1.       Be in the top 4,000 of U.S. companies by market cap, and have market cap over $30 million

2.       Trade on major U.S. exchanges – over-the-counter and pink sheets excluded

3.       Meet Russell’s growth and price-to-book style criteria

4.       Have a minimum $1 stock price at the end of May

Then the companies are broken down into the respective indexes as per the following table:

As small cap investors we’re mainly interested in changes to the Russell 2000 small cap index, but it’s a good idea to know how the entire index lineup is designed. I’ve made the case repeatedly that small caps deserve a place in your portfolio. Here’s one more reason: so far this year the Russell 2000 index is down 1.3 percent, proving slightly more resilient than the S&P which has a loss of 5.6 percent over the same period.

After the market turbulence that bridged 2008 – 2009, the 2009 Russell Reconstitution was accompanied by a sharp decrease in market cap thresholds. With the deflated value of many stocks, the powers that be placed the small cap cutoff at only $78 million last year.

Stocks have rallied hard over the last year, and many small caps in particular have risen by over 100 percent. This could lead to a ton of turnover during the rebalance and it’s likely that the small cap cutoff will be significantly higher than last year’s $78 million.

***So what’s the profit opportunity?

The theory behind taking advantage of the rebalance follows a simple premise:  As the Russell composition changes, portfolio managers tracking the index will have to buy and/or sell as needed so their holdings reflect the composition of the ‘new’ Russell index.

Companies that investors expect will be added to the index tend to see a run-up in their stock prices, while those that get the boot usually see a drop in share value. So, buy the right stocks ahead of time and you can ride their share prices higher. And avoid the stocks that face the axe and you can preserve capital.

Sounds pretty simple, right?

This theory does actually work. If you pick and choose the right companies before they’re added, you’re likely to make a profit.

A 2003 academic paper published in Financial Analysts Journal named the ‘Russell Reconstitution Effect’ looked at returns from the addition/deletion effects of 1996-2002. The authors made an average return of 15% by simply trading the reconstitution over the month of June. That’s a pretty nice one month return.

What’s more, on the effective day of the 2009 reconstitution, Russell 2000 adds rose by 8.8 percent, while those cut fell by 13.1 percent. That’s a nearly 22 percent spread!

The real opportunity here is to find solid companies that are likely to be included in the new Russell – and just buy the best ones.

Inclusion in the Russell 2000 small cap index can give a strong company the additional publicity and prestige it needs to make its share price pop. More specifically, inclusion means analyst attention, a broader investor base, increased liquidity and greater exposure to institutional investors. There is clearly a lot of upside potential in a fundamentally good stock that meets all of the criteria needed to make it into the new Russell 2000 index.

***In future issues of Small Cap Investor Daily, I’ll discuss a few companies that I believe have a good shot of making the new index. I’m looking for small-cap stocks that meet the Russell Reconstitution criteria and have solid upside potential. This way we’re looking at good companies, whether or not they’re added in June.

A few companies that have piqued my interest include a gold mining and exploration company, a medical devices firm and a semiconductor testing company.  If you have any stocks you think will make the cut shoot me an email. My address is: editorial@smallcapinvestor.com. 

The Russell Reconstitution presents a big opportunity for small cap investors, and is one of the best short-term trading periods of the year. It also gives us the chance to have a little fun while seeking out profits.