Russell Methodology Changes - Heavy Implications for China Small Caps

A couple of weeks ago I posted a preview for the upcoming reconstitution of the Russell 2000 Index and the possible implications for U.S.-listed China Small Caps. New developments have made basically all the assumptions in that article outdated as Russell made several adjustments to their methodology which will make most China stocks no longer eligible for inclusion in the U.S. Indexes.

Russell is implementing a new rule to determine country assignment for their U.S. and Global Indexes. A "U.S. Company" is no longer just defined by country of incorporation and most liquid exchange, therefore not each China Small Cap which is incorporated in the U.S. and traded on a senior exchange will be automatically eligible for the Russell 2000 anymore. Instead Russell will introduce three so-called "Home Country Indicators":

• Country of Incorporation
• Country of Headquarters (address of principal executive offices)
• Most Liquid Exchange (by 2 year average daily dollar trading volume)

Companies which are incorporated, headquartered, and trade in the U.S. are eligible for the Russell 2000 Index if they meet all the other requirements (minimum float etc.) and make the market capitalization cut on May 28. If any of the three Home Country Indicators do not match, the primary location of assets will be used to determine eligibility. If the primary location of assets matches one of the three Home Country Indicators, the company is assigned to that country. Should the location of assets be inconclusive, Russell will use the primary location of revenues. If that is inconclusive as well, Country of Headquarters will be used as the final determination. All companies that are not assigned to the U.S. by those Home Country Indicators will no longer be eligible for the U.S. Indexes and instead be added to the Russell Global ex-U.S. Index.

Historically, asset owners have diversified their risk by assigning assets to specific countries. Some companies incorporate in a specific country for tax reasons while some chose a higher tax structure for the trade-off of access to capital. Therefore, to most closely track country risk, Russell uses objective criteria to assign countries to the U.S. equity market. All companies which Russell determines to be part of the U.S. equity market are included in the Russell U.S. indexes. Those determined to be non-U.S., using the same criteria, become members of the Russell Global ex-U.S. Index.

Further reading:
Russell U.S. Index Construction & Methodology (PDF)
Identifying "Country of Risk" in the Wave of Globalization

I have updated the Russell 2000 - Reconstitution Screen for China Small Caps to show both Country of Incorporation and Country of Headquarters for all U.S.-listed Chinese stocks that we are tracking. Only 2 out of the 29 stocks that are currently included in the Russell 2000 Index are both incorporated and headquartered in the U.S., and as most (if not all) of those names have most of their assets and derive most of their revenues in China, it is very likely that those other stocks will no longer be eligible for the 2010 U.S. Indexes. The two stocks that still meet all criteria are HQ Sustainable Maritime (HQS) and Advanced Battery Technology (ABAT), where HQS's market capitalization is currently down to $73 million which makes it unlikely that the stock will be above the May 28 threshold.

There are six more China Small Caps which are incorporated, headquartered, and trade in the U.S. and would be eligible for the Russell 2000 to the best of my knowledge: Aoxing Pharmaceuticals (AXN), China Advanced Construction Materials (CADC), China Armco Metals (CNAM), China Direct Industries (CDII), China North East Petroleum (NEP) and L & L Energy (LLEN). LLEN should safely meet the requirements for minimum market capitalization, NEP and AXN both have a good chance to make the cut as well. The other three are currently valued with less than $60 million and most likely will not be within the 3000 largest U.S. companies at the end of this month.

What does this mean for trading China Small Caps in June? Russell will rank all the eligible stocks by their total equity capitalization as of May 28, which means we have one week of trading left. Preliminary additions and deletions to the Russell Indexes are published on June 11 after the market close. We might see additional weakness in stocks that are likely to be deleted from the index throughout June, with huge volatility and massive volume on June 28, the reconstitution day.

Many of the stocks likely to be deleted are financially sound with high growth projections for the next couple of years. There is no other option for portfolio managers tracking the Russell 2000 index than selling those names into the June 28 deadline, and seemingly irrational drops in stock price will likely present excellent buying opportunities as trading in those deleted names does usually normalize very quickly after the reconstitution day. Some tickers to watch are CAAS, CGA, CHBT, CPBY, CPSL, FEED, FSIN, HOGS, HRBN, NIV, UTA and WATG.

It might be rewarding to speculate on a Russell 2000 addition of LLEN, NEP and AXN, but I can't give any guarantee that this is actually going to happen. The new rules will be executed for the first time this year and we do not know yet how those names - who are no different in asset/revenue location than the others - will be treated by the Russell managers.