Thursday, June 21, 2012

Stock Market Inefficiency You Can Set Your Watch To

It's that time of year again.  The time of year of which every small cap money manager is acutely aware: the annual rebalancing of the Russell 2000 Index.

The Russell 2000 is the de facto standard in small cap equity benchmarks.  It's tracking ETF, the iShares Russell 2000 (IWM), has a whopping $15 billion in assets.  That's a lot of money moving around in what can be a very illiquid asset class (the smallest stock in the index today has a market cap of only $7.7 million).  So when Russell makes its once-a-year additions and deletions to the index at the end of June, it can create some very interesting movements in stock prices.

Consider this: while the Russell 2000 Index overall is up 3.3% year-to-date, the 123 stocks being deleted from the index are down an average of 23.9% and the 189 stocks being added are up 49.0%.  While companies that have seen their stock prices decline over the past year are naturally the ones who are most likely to be booted from the index, these stocks have seen accelerated selling pressure ahead of the rebalancing as investors anticipate the event.

All of which creates an interesting quandary for the efficient markets crowd: what happens when stock prices move significantly for reasons clearly not related to the economic value of a firm?

Perusing the list of stocks that have been sorely punished for the simple reason that they will no longer be included in a passive index, we have found numerous examples of extreme mis-pricing.  Several stocks trade below their net working capital (liquidation value).  Several others trade at low single-digit multiples of cash flow.  A few have seen consensus estimates of their sales and earnings rise recently while the stock was falling precipitously.  These are not rational valuations but rather the result of mindless trading.

While the stock market is efficient much of the time, there are periodic pockets of inefficiency that are often easily distinguishable and predictable.  In the small- and micro-cap universe, these pockets are more frequent and generally of greater magnitude.  To the patient and intelligent investor, these occasional moments of insanity are the fun parts.