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The Russell 2000 is scheduled to be reconstituted this summer. The process entails ranking companies by market capitalization on May 31, and publication of preliminary additions and deletions on June 14. A new membership list is to be made available on July 1. While inclusion is typically a status-conferring boon, problems stemming from removal need discussion. This article focuses on three relevant companies.

May 31, 2012 data shows the index's current market capitalization range. The high is just over $2.6 billion and the low is $101 million. The median company in the Russell 2000 is listed at a $460 million market cap. Smaller constituent corporations with dimming prospects are in danger of removal along with substantial losses in size and share price.

Membership in indices can be empirically observed through the number of shares that are held in exchange-traded funds that track them. As of today, the iShares Russell 2000 Index (NYSEARCA:IWM), iShares Russell 2000 Growth Index (NYSEARCA:IWO), and iShares Russell 2000 Value Index (NYSEARCA:IWN) hold roughly 2.2% of the outstanding shares of three stocks at risk of deletion this summer. A table follows, the source of the data is Yahoo Finance:

Market Capitalization

(4/13/13)

Current Shares Outstanding

Russell 2000 Index Holdings

Other Russell 2000 Index Holdings

Total Russell 2000 Index Shares

The Cherokee Group, Inc. (NASDAQ:CHKE)

$112.39 million

8.4 million

131,241 shares

51,637 shares

182,878 (2.18%)

The Eastern Company (NASDAQ:EML)

$101.93 million

6.22 million

93,160 shares

45,255 shares

138,415 (2.23%)

Omeros (NASDAQ:OMER)

$104.4 million

25.91 million

392,624 shares

182,098 shares

574,722 (2.22%)

Omeros

I have written about Omeros previously, here and here. It is a biopharmaceutical firm that maintains analysts' favor, with a mean recommendation of 1.4. The share price's recent steep decline from well over $5 to around $4 does not appear to be backed by rationality. Indeed, the company's prospects, though entirely speculative, have been improving during the same time.

However, one clear concern about Omeros is its financial condition. Unfortunately, the case may now be that dilution through either of its agreements that are in place, with Azimuth Opportunity Ltd. or MLV & Co., LLC, before the conclusion of the second quarter at June's end, could lead to a market cap under $101 million. Even if this does not happen, there is a risk of being replaced by a different company that has grown into the Russell 2000's criteria.

Omeros also has near-term prospects that can easily result in an increased market capitalization before June. It does not appear sensible to bet against, as its price has already fallen to near its 52 week low (Nasdaq shows the short interest declining). Though its cash is running lower, there are also three potential upside catalysts: Fast Track and Orphan Drug applications for a product in clinical development, and a New Drug Application for another candidate that has recently finished Phase 3 trials. Uniquely qualified personnel are working on them. If the company's continued press releases keep saying what the market wants to hear, everything could be fine; if not, at least 2% of its shares stand to be liquidated by funds.

The Cherokee Group, Inc.

The situation appears much worse for Cherokee and I am inclined to bet against it. It is expected to report on Thursday, April 18th. Only one analyst covers its stock, and according to that person's figures posted on Yahoo it is quite expensive, trading at 13x 2014 estimated earnings with a 2% five year growth rate. Its October 2012 balance sheet shows $1.5 million in cash compared to $10.4 million in long-term debt, and $2.6 million in current liabilities. The company just hired a new CFO, after his predecessor's February 25th resignation, and he is stepping into a corporation that has lost cash through each of its past five quarters.

Remarkably, according to Nasdaq, Cherokee's short interest is only 187,948, or 2.7%, which is under half of what it was in November. The figure for days required to cover rounds up to 9.5, so a short squeeze can still happen.

Cherokee describes itself as a global marketer and manager of a portfolio of fashion and lifestyle brands. It makes its money through royalties. Its products are licensed in 40 countries and it does approximately $2 billion in annual retail sales, in large part through Target Corporation (NYSE:TGT) and HSN, Inc. (NASDAQ:HSNI) in the U.S.A. According to the December, 2012 10-Q, 58% of the company's Third Quarter licensing revenues ($6,730,000 total) are attributed to Target. International royalties are listed as comprising a much smaller amount, at 37.1% of the total figure.

A March 2013 Investor Presentation shows annually deteriorating earnings and net income since 2008 (slide 17 of 36). It also specifies key drivers as organic growth, new retail partners, and strategic acquisitions. Per its December 2012 10-Q, in order to make a September 2012 purchase, JP Morgan Chase (NYSE:JPM) has lent the company $13 million under terms that restrict Cherokee's ability to sell stock. Given the company's financial statements, any further acquisitions probably should be small and immediately accretive. Thus, chances are it needs organic growth and new retail partners in order to show improvement.

The company is also exposed to changing exchange rate risks. A weakened dollar is better for Cherokee because foreign licensees pay in U.S. dollars, not their own currency. A 10% strengthening of the dollar would result in approximately a 3.5% loss in total revenue (10-Q pp 13 and 16 of 26). Meanwhile, there is continuing talk about a deteriorating situation in Europe, with newer questions about Slovenia, and there is no obvious near-term reason for the dollar to weaken. Currency valuations are not a central reason to sell short shares of CHKE; though they do not appear to be working to the stock's advantage.

CHKE pays a $0.10 quarterly dividend, yielding 2.99% at its current $13.38 share price, which is not guaranteed. For reference, the Russell 2000 itself yields 1.38%. Target's dividend is lower than CHKE's, paying $0.36 quarterly, to yield 2.07% at its current $69.49 share price. Target is part of the S&P 500 and seems to be an apt hedge.

The Eastern Company

The Eastern Company's prospects might be questionable. Yahoo Finance shows no analyst coverage or earnings estimates. However, its cash position is a decent $18.482 million as of December 28, 2012, against six million in long-term debt. Its short interest has been consistently low, at around 94,000 and just over 2%, with the days to cover at 12 due to low volume.

As a strength, it has produced cash in each of the past four quarters.

The company manufactures industrial hardware, metal castings, and security products with operations in the U.S.A., Canada, Mexico, Taiwan, and China. Its last quarterly report contains several positives, including year over year gains of 10% in net sales and 57% in net income; and earnings of $0.28 per share, an 18% year over year increase. It pays a $0.10 quarterly dividend and yields 2.44% at its current $16.39 share price.

There is a danger for EML shareholders that the stock can be deleted from the Russell 2000. However, for a nice and agreeable article, see The Eastern Company: A Value Play With Major New Product Potential.

Summary

Three companies with market caps that are currently close to $100 million may face increasing chances of widespread selling and a loss of status at the end of next month. A bet against Omeros would probably require difficulty on multiple FDA applications that are being completed by impressive personnel to be successful. The Eastern Company appears otherwise healthy. Cherokee has problems, and I am looking into buying shares of TGT as a hedge against a potential short position, with its anticipated Thursday Report in mind.

Source: Micro Caps Can Be Especially Risky In The Russell 2000

Additional disclosure: A long position in Target (TGT) may be initiated in the next 72 hours as a hedge against a possible short position in CHKE within the next 72 hours.