Big Moves Are Coming For These Small Caps

by: Mark Gomes

Beating the S&P isn't easy. However, three months ago, we offered picks that we claimed would beat the market by 15% before July. These picks were based on a proprietary research method that took four years to develop. The objective was to identify the most explosive stocks that portfolio managers will be forced to buy and sell when the Russell 2000 (R2K) is reshuffled at the end of June.

With just two weeks to go, our picks have performed commendably. Here's our performance as of Friday, June 14:

Company Ticker Position Initial Price Current Price Current Return Peak Return
Media General MEG Long 5.50 9.62 75% 85%
Perfumania PERF Short 5.91 5.75 3% 11%
PDI, Inc. PDII Short 6.08 4.30 29% 37%
LCNB Corp. LCNB Long 16.98 18.63 10% 13%
Palmetto Bancshares PLMT Long 11.98 13.92 16% 33%

With an average holding period of just six weeks, this year's picks are up an average of 25%. Our longs are up 30% and have risen as much as 40%. Our top performer, Media General, just announced it was entering into a merger agreement, which effectively amounts to a buyout. The shares jumped 34% on the news, adding to already-stellar performance this year.

Our shorts have earned 17% with a peak average return of 24%. Even though the market is up nicely since March, both of our short picks have gone down, generating a solid profit for investors.

So What's Next?

On Friday, Russell announced the preliminary list of additions and deletions. We are pleased to announce that every single name we selected is on the list! This 10-for-10 performance tops our strong 5-for-6 record, set in 2011. But our job isn't done, yet…

Over the next two weeks, Russell Investments will scrutinize their list to ensure each company belongs (or warrants being removed). After updating our calculations this weekend, we are maintaining our stance on each of our five official selections. Specifically, as of today, we expect MEG, LCNB Corp., and Palmetto Bancshares to be added to the Russell 2000.

In less than two weeks, Russell Investments will officially complete the annual reshuffling of its indexes. Dozens of portfolio managers will be required to buy the new additions and sell the deletions. This will create millions of dollars of demand (or selling pressure) for the winners (or losers)… all on one day, June 28. However, it's not as simple as that. A number of market machinations will be at work, which will ultimately determine which stocks produce gains for investors (and which produce losses).

We'll provide details and guidance in the days ahead. In the meantime, here are some updates to our 2013 selections:

UCFC - We recently re-ran our models to see if any low-hanging fruit remained. One stock stood out: United Community Financial Corp. (NASDAQ:UCFC). UCFC has a market cap of $167 million and a book value of $170 million. It has had spotty performance over the past few years, but the company seems to be turning the corner toward consistent profitability. In the latest earnings release, CEO Patrick W. Bevack stated:

"Net income for the quarter, along with improvement in asset quality and the successful completion of the private equity offering continues to move our Company forward. These positive steps provide United Community and Home Savings with the capital to grow our Company, raise our capital levels to levels that are commensurate with our risk profile and continue to execute our business plan."

According to our R2K model, UCFC has shored up its capitalization in recent months. As a result, it looks like a great bet to be added to the Russell. Based on its average trading patterns, the stock could see some strong demand in the weeks ahead. However, due to the nature of its recent capital raising, we only added UCFC as an unofficial selection.

LCNB - This was a riskier selection, but it has more explosive potential, so we took a shot… and it paid off. LCNB was on Russell's preliminary list and we expect it to make the final cut. More importantly, we calculate that portfolio managers will have a hard time accumulating the required number of shares of LCNB without driving the stock higher. This should be bullish for the stock over the next two weeks.

PLMT - Palmetto has a similar profile as LCNB, but was a safer choice to join the Russell. That remains the case. While LCNB's odds have risen dramatically with its preliminary listing, PLMT is still a surer thing. Thus, an investor can take their pick based on how much risk (and reward) they want to go for.

On the short side:

PERF - With two weeks to go before Russell Investments locked in its ranking list, we calculated that PERF would have to rise by more than 50% to avoid deletion. It didn't. Accordingly, Russell Investments has preliminarily stated that PERF will be deleted from the Russell 2000 on June 28. Considering its fundamentals and trading profile, it's a good bet to fall in value between now and then.

BERK - Berkshire Bancorp has been on our unofficial list to be deleted since March. At the time, it was on the Russell bubble. That changed on Friday when BERK was listed among the preliminary stocks to be deleted. As a reminder, BERK is the holding company for a fairly typical bank (providing retail and commercial banking services). It has a market cap of $115 million, which compares favorably to its book value of $137 million. However, due to low interest rates, the company has been producing lackluster profits. Over the past 12 months, it has only been able to muster $7 million of operating cash flow. This is nearly half of the cash flow we've seen from similar entities. As a result, BERK only offers a 1% dividend.

Due to nearly non-existent investor interest, we believe Russell fund managers will have a hard time unloading its shares (something they will be forced to do on June 28 if the company is officially deleted from the Russell next week). We are confident this will occur, which makes BERK a solid bet on the short side.

Stay tuned. We'll be continuing our special coverage of the 2013 Russell Reconstitution throughout this week, leading to the grand finale on June 28.

Disclosure: I am long PLMT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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