Russell 2000 Reconstitution Preview

IMPORTANT: This post has been updated (click here)

The Russell 2000 Index's annual reconstitution is an event every small cap investor should be prepared for and watch closely. Inclusion in the world's leading small cap index has enormous benefits for the growth stocks I am covering here on this blog, including much enhanced liquidity, gaining a larger investor base and especially much broader exposure amongst institutional investors and independent analysts.

For those of you who are not familiar with the Russell methodology, here is how it works. Russell will rank the US common stocks from largest to smallest market capitalization on the last trading day in May. The largest 1,000 stocks become the Russell 1000 Index and the next 2,000 stocks become the Russell 2000 Index. Excluded are stocks trading below $1.00, pink sheet and bulletin board stocks, foreign stocks and American Depositary Receipts (ADRs), and closed-end mutual funds, limited partnerships, royalty trusts, SPAC's etc.

For 2010 the relevant dates are the following:

• May 31: Stocks will be ranked by market capitalization
• June 11: Preliminary additions and deletions to the Russell Indexes published after 3:00 pm PST
• June 18: Updates to the list of additions and deletions
• June 25: More updates and final reconstitution after the close of the US markets

There is a potentially enormous addition/deletion effect on the stock price of the added or dropped companies. Asset managers whose portfolios reflect the composition of the Russell 2000 will need to buy or sell stocks in proportion to their new weighting. That will make June 25 most likely the busiest trading day of the year with record turnover and huge volatility especially into the close. For 2009 NASDAQ reported a new record with 1.002 billion shares representing $9.2 billion executed in the Closing Cross in 2.9 seconds.

Now, in theory, new additions to the index should appreciate in price in anticipation of the June 25 action while deletions should see some selling pressure as soon as their preliminary deletion is announced. Thinly traded stocks should on average see the highest volatility and biggest price jumps. If we can identify likely candidates for both additions and deletions early, we can possibly make good returns with taking positions in those stocks before preliminary index changes are announced.

Let's have a look at potential candidates in the China small caps space and - most importantly - what could the market cap threshold for entry into the 2010 Russell 2000 Index be.

Last year the market cap threshold was just $78 million, a record low since 1993 and down from $167 million in 2008. The reason for this big drop was that at the end of the financial crisis downturn, when mid- and larg-cap companies held up relatively well, small caps were still underperforming the general market. As we all know this has changed dramatically over the last twelve months.

From May 31, 2009 until today (April 30, 2010), the Russell 2000 gained 42.86%, which is a far better performance than the general market as measured by the S&P 500 which gained "just" 29.11% in that period. Year-to-date the Russell 2000 outperformed the large cap Russell 1000 as well with a return of 15.01% compared to 7.65%.

We can safely assume that this year's market cap threshold will be much higher than 2009's $78 million and many of last year's addition will be deleted again if they haven't at least doubled in price. I will go with a threshold of $150 million for now, treating companies with a market cap between $120 million and $180 million as uncertain candidates.

Current Russell 2000 Members		Market Cap
CAAS	China Automotive Systems	$703 million
HRBN	Harbin Electric	$680 million
HOGS	Zhongpin	$437 million
CHBT	China-Biotics	$429 million
CSR	China Security & Surveillance	$411 million
WATG	Wonder Auto Technology	$393 million
CFSG	China Fire & Security	$378 million
ADY	American Dairy	$373 million
SDTH	ShengdaTech	$372 million
AOB	American Oriental Bioengineering	$363 million
FSIN	Fushi Copperweld	$331 million
CAST	ChinaCast Education	$304 million
CPBY	China Information Security	$299 million
CGA	China Green Agriculture	$295 million
FUQI	Fuqi International	$270 million
DYP	Duoyuan Printing	$253 million
COGO	Cogo Group	$252 million
ABAT	Advanced Battery Technology	$240 million
CSKI	China Sky One Medical	$237 million
GSI	General Steel Holdings	$193 million
FEED	Agfeed Industries	$193 million
CTFO	China TransInfo Technology	$158 million
UTA	Universal Travel Group	$152 million
NIV	NIVS IntelliMedia Technology	$131 million
CBAK	China BAK Battery	$126 million
CHLN	China Housing & Land Development	$110 million
SUTR	Sutor Technology	$104 million
HQS	HQ Sustainable Maritime	$84 million

Based on Friday's close I would expect only China Housing, Sutor and HQS to be deleted from the Russell 2000, and four more stocks being at risk. Of course there is still a full month to go and things could change dramatically from here on. Now let's have a look at possible additions from the China small cap space.

Possible Russell 2000 Addition		Market Cap
CCME	China MediaExpress	$535 million
RINO	RINO International	$493 million
SCOK	SinoCoking Coal	$474 million
CBEH	China Integrated Energy	$426 million
GFRE	Gulf Resources	$371 million
CVVT	China Valves Technology	$347 million
YONG	Yongye International	$340 million
CXDC	China XD Plastics	$301 million
LLEN	L&L International	$297 million
CAGC	China Agritech	$281 million
CBPO	China Biologic Products	$281 million
SHE	Shengkai Innovations	$262 million
LIWA	Lihua International	$256 million
DEER	Deer Consumer Products	$240 million
CNYD	China Yida Holding	$237 million
NEP	China North East Petroleum	$212 million
CELM	China Electric Motors	$196 million
SORL	SORL Auto Parts	$194 million
CHNG	China Natural Gas	$193 million
QKLS	QKL Stores	$170 million
PUDA	Puda Coal	$165 million
TBV	Tiens Biotech	$163 million
ONP	Orient Paper	$155 million
CMFO	China Marine Food	$150 million
CREG	China Recycling Energy	$146 million
CPHI	China Pharma Holdings	$146 million
CEU	China Education Alliance	$146 million
TSTC	Telestone Technologies	$144 million
WWIN	Winner Medical Group	$140 million
YUII	Yuhe International	$140 million
CNGL	China Nutrifruit	$138 million
BSPM	Biostar Pharmaceuticals	$129 million
SPU	SkyPeople Fruit Juice	$123 million
CWS	China Wind Systems	$113 million
KNDI	Kandi Technologies	$107 million
TPI	Tianyin Pharmaceutical	$107 million
AXN	Aoxing Pharmaceuticals	$100 million
ALN	American Lorain	$96 million
CRTP	China Ritar Power	$94 million
GRPC	Guanwei Recycling	$88 million

Our screen identifies a large number of Chinese stocks that will probably make the cut. Many of the names on this list are companies which uplisted from the bulletin boards since March 31, 2009 and this year's reconstitution will be their first chance to get added (Russell is only adding regular IPO's like DYP on a quarterly basis). Some of those names like CAGC, RINO or the coal stocks are already trader's favourites and the announcement of their addition will likely get a lot of buzz because of the stocks' popularity. Other names on this screen do currently have a small investor base and trade on very thin volume. I would expect the addition effect for stocks like CNYD or SHE to be greater than average.

I will make adjustments to the China Model Portfolio shortly, based on the results of this screen: Russell 2000 - Reconstitution Screen for China Small Caps.