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Mark Gomes, PTT Research (1,246 clicks)
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Beating the S&P (SPY) is a challenge for many money managers. However, for nimble investors, there are many ways to stay ahead of the averages. For example, at the end of May, Russell Investments will initiate its annual reshuffling of the Russell 2000 index (also referred to as "the Russell" or R2K). This annual event represents a juicy opportunity for investors who identify the winners (and losers) before they are selected.

When the new list of Russell stocks is announced, ETFs and other funds will be obligated to buy the new additions (and sell off the stocks that get deleted). This will create millions of dollars of demand in the lucky companies' shares (and tremendous selling pressure in the losers). Being early to buy, sell, or short the right names is a perennial money-maker.

Last year at this time I was on a hiatus. However, in 2011 my company (Pipeline Data) went 5 for 5 in our picks to get added to the Russell. In addition, our top short candidate was deleted. Most importantly, all six stocks beat the market, returning an average of 11% in just six weeks. That represented more than 15% outperformance over the Russell and S&P 500.

By placing a bet on each of these names and an offsetting bet on the Russell or S&P, investors created a technically risk-free portfolio that paid off nicely. In an environment where safe yield is hard to find, this strategy should have even greater appeal this year.

A few things make this kind of performance a reality:

  1. Large institutions generally don't play with companies with market caps under $200 million.
  2. Russell index funds have no choice but to buy or sell the names that get added and subtracted from the index. More importantly, they have to wait until Russell releases the official list (in June).
  3. The two aforementioned factors empower retail investors to front run the index funds by speculating on which companies will get added or deleted.
  4. Generating a list of potential winners is easy. However, screening that list against Russell Investment's qualifying standards (along with fundamental risks, trading characteristics, etc.) takes weeks of work. But as we saw in 2011, the reward makes it well worth the effort.

So, who will be added and dropped this year? Market cap will be a major determinant. This year, we believe that companies with market cap above $150M are high conviction bets to be added. Conversely, current Russell 2000 companies whose market caps have fallen below $100M will likely be deleted. Anything in between could go either way. We estimate there are about 50 candidates on each side of the equation.

In the coming weeks we will present several candidates. Today, we present three (1 long, 1 short, and a wild card):

Media General (MEG) -- LONG

Price

5.50

Market Cap

150M

Float, excluding institutional holdings

7.2M shares

Short Interest

4.4M shares

Average Volume

127,000 shares

Media General's market cap has risen due in part to a solid year of results. Last year, the company sold 63 of its newspaper franchises to Warren Buffett's Berkshire Hathaway (BRK.B). Berkshire also supplied MEG with a $400M term loan, bolstering the company's financial position.

The company has another famous shareholder in the form of Mario Gabelli. Gabelli actually saw fit to participate in the company's most recent earnings call. You can view the transcript on Seeking Alpha.

MEG's combination of float and short interest should have investors salivating. The company's float is 7.4 million shares, with short interest representing 4.4 million shares (59% of the float). With average volume of 127,000 shares, this will be a very tough stock to accumulate (or cover) if it gets added to the Russell.

This is a dream scenario for long investors and nightmare for the shorts. Further, Q1 earnings should provide a boost to the longs. On March 5, management confirmed its Q1 guidance and provided a positive view into the rest of 2013. With just a couple of weeks left in the quarter, it appears that Q1 will be solid. We believe that the combination strong earnings and admission into the Russell could spark a short squeeze, accentuating investors' returns.

Perfumania (PERF) -- SHORT

Price

5.75

Market Cap

90M

Float, excluding institutional holdings

3.5M shares

Short Interest

0.1M shares

Average Volume

9,000 shares

Perfumania is a wholesale distributor and specialty retailer of perfumes and fragrances. It operates approximately 350 Perfumania stores, Perfumania.com, and SOW, which sells fragrances on a consignment basis in approximately 2,300 stores (including more than 1,300 Kmart locations).

It's a fairly stable company, but has a spotty history of profitability. Most recently, February same store sales were down 9.2%. Investors also have to consider the effect of increasing competition. Of course, Amazon (AMZN) poses a major threat from the Internet channel. On the four-walls front, Ulta (ULTA) has been growing rapidly. In recent years, ULTA has gained prominence and has opened many locations near Perfumania stores.

During the past year, PERF's stock has declined by over 30%. Consequently, PERF's market cap has fallen well below $100 million - far too low to remain in the Russell unless its shares rise 65%+ in the next 12 weeks.

That scenario is unlikely, making a PERF a good bet to short right now. If and when the company is removed from the Russell, based on its average daily volume, we believe that a couple months' worth of shares will need to be sold by Russell fund managers. With same store sales falling, competition intensifying, and less than $2 million of cash on Perfumania's balance sheet, we struggle to identify who might want to buy those shares.

Of course, if nobody steps in, the shares could revisit their 52-week low of $4.13, which is about 30% below current levels.

Uni-Pixel (UNXL) - Wild card on the long side

Price

27.37

Market Cap

273M

Float, excluding institutional holdings

4.2M shares

Short Interest

2.5M shares

Average Volume

700,000 shares

Due to some legal risks and its recent trading activity, this is not an official Pipeline Data R2K pick. However, barring a disaster, we believe this company will be added to the Russell 2000. For those of you who enjoy a little extra risk, this one might be for you.

Uni-Pixel's market cap has risen thanks to a multi-million dollar contract it recently signed for its metal mesh touch sensors. The deal, made with a PC manufacturer, is being seen as a sign that its metal mesh touch technology has what it takes to cross the chasm and win many more deals with large technology vendors. You can find in-depth research on this development on Seeking Alpha.

Assuming UNXL maintains its current market cap, we believe it will be admitted into the Russell 2000. This alone should make short sellers very nervous. The float is 8.8 million shares, but 4.6M of that is held by institutions. This leaves just 4.2M shares in retail hands against a 2.5M short interest. In other words, being added to the Russell will likely incite a short squeeze.

In fact, if it becomes widely known that UNXL is likely to be added to the Russell, a short squeeze could ensue months before the official announcement. Considering the recent explosion in social networking, we believe the odds of this are quite high.

On The Bubble

A few stocks to watch in the coming weeks include Berkshire Bancorp (BERK), Craft Brew Alliance (BREW), Key Tronic (KTCC), and Peoples Federal Bancshares (PEOP). Each of these are susceptible to bear raids that could knock them out of the Russell. If they succumb, it would add further selling pressure to the shares.

More to come…

We'll be issuing more Russell picks and updates in the weeks ahead, exclusively on Seeking Alpha. To get the latest picks automatically, simply hit the "Follow" button under my picture at the top of this page.

Source: Stocks To Beat The S&P By 15% Before July

Additional disclosure: I am short SPY and PERF. I may also initiate short positions in BERK, BREW, KTCC, and PEOP.