Post Re-Org Equities: Russell 1000/2000 Index Changes

In 2006, Baupost's founder and president Seth Klarman gave a talk at Columbia Business School. In his talk, Klarman noted that Baupost has analysts that focus on very specific events: spin-offs, post re-org equities, distressed debt, etc. One set of analysts that I had never heard of a fund employing: analysts that focused on the addition and deletion of stocks in certain indexes like the S&P 500. As one would expect, when a company gets added to the index, passive funds (mutual or ETF) must buy the quantity of stock needed to match the company's weight in the index. Conversely, a stock that is removed from an index will see "forced selling" of their equity as passive strategies sought to match the index components.

In fact, this is one of the reasons that Seth Klarman, arguable the best hedge fund manager out there and one of three people Buffett has said he would allow to manage his money (source: Bruce Greenwald), has said why indexing is such a dangerous strategy (from Margin of Safety):

"Another problem arises when one or more index stocks must be replaced; this occurs when a member of an index goes bankrupt or is acquired in a takeover. Because indexers want to be fully invested in the securities that comprise the index at all times in order to match the performance of the index, the security that is added to the index as a replacement must immediately be purchased by hundreds or perhaps thousands of portfolio managers. There are implicit assumptions in indexing that securities markets are liquid, and that the actions of indexers do not influence the prices of the securities in which they transact. Yet even very large capitalization stocks have limited liquidity at a given time. Owing to limited liquidity, on the day that a new stock is added to an index, it often jumps appreciably in price as indexers rush to buy. Nothing fundamental has changed; nothing makes that stock worth more today than yesterday. In effect, people are willing to pay more for that stock just because it has become part of an index...

A related problem exists when substantial funds are committed to or withdrawn from index funds specializing in small-capitalization stocks. (There are now a number of such funds.) Such stocks usually have only limited liquidity, and even a small amount of buying or selling activity can greatly influence the market price. When small-capitalization-stock indexers receive more funds, their buying will push prices higher; when they experience redemptions, their selling will force prices lower. By unavoidably buying high and selling low, small-stock indexers are almost certain to underperform their indexes. "

On June 10th, Russell announced their annual reconstitution preliminary additions and deletions. You can view the data here: Russell Reconstitution. On Friday, June 24th the reconstitution will go into effect.

We know over the past year that a number of post re-org equities have been listed on the exchanges. With that said, we would expect to see a number of post re-org equities in the addition column on the Russell indexes and that's actually what we see. Here are the list of post-re org equities, and the associated Russell (either 1000 or 2000) indices they are being added to:

• BKU - BankUnited (Russell 1000)
• GM - General Motors (Russell 1000)
• CHMT - Chemtura (Russell 2000)
• CHTR - Charter Communications (Russell 1000)
• FRP - Fairpoint (Russell 2000)
• LYB - Lyondell (Russell 1000)
• SEMG - SemGroup (Russell 2000)
• SIX - Six Flags (Russell 2000)
• VC - Visteon (Russell 1000)

What compounds the problem on some of the smaller stocks above, is that the free float may be a very small percentage of total shares outstanding. As some bankruptcy plan support agreements require fulcrum security holders to hold onto their stock for a certain number of days, the true liquidity of a stock may be quite small. Furthermore, there may be no equity holders, that participated in the bankruptcy, ready to sell the stock because a lack of value realization.

Let's take Six Flags as an example. Bloomberg lists 27.575M shares outstanding. The new proposed weighted in the various indices (Russell 2000, Russell 3000, and Russell 2500) will require a purchase of approximately $111M worth of shares, or approximately 1,500,000 shares as of today's close. Since the end of the 1st quarter, the average volume of the stock is approximately 160,000 shares. This is 9 days worth of volume just on the passive side. Rehan Jaffer's H Partners, a well know event-driven hedge fund, owns 6.6M shares or ~25% of the shares outstanding. If he (and BHR Capital, the #2 holder) decides to not sell into the passive investor's hands, there could be a squeeze for the shares pushing the price artificially higher.

I would expect a small bump in the stocks listed above in the last week of the month as Russell passive funds look to match the new index constituent lists. Likewise, while not post-reorg equities, a number of the very small companies that did not make the market cap minimum this year on the Russell 2000 will be deleted from the index. Somtimes already illiquid, investors may see some interesting value opportunities in the names. These include PCTI, TPGI, AMNB, HOFT, and CUTR. Happy hunting.