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A risky but rewarding way to bet on rising stars

There is money to be made in buying stocks that few people know about. In the coming weeks, however, there's a more unusual opportunity – a chance to make money on stocks that will soon be known just a little bit better.

These are the U.S. stocks that will soon be plucked from obscurity and named to the Russell 2000 Index. When this happens, they will be bought by managers whose mandate is to track the index – and their share prices should jump as a result.

To be sure, it's difficult to predict which stocks will be the lucky ones. But the rewards can be considerable, according to one study.

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Before we get to the details of that study, some background. The Russell 2000, created by Russell Investments, attempts to capture the performance of small-capitalization U.S. stocks. The stocks in the Russell 2000 place from 1,001 to 3,000 in a ranking of U.S.-based equities based on market cap and several other factors.

With the exception of initial public offerings, which enter the index quarterly, Russell Investments reconstitutes the 2000 just once a year, in June. Since the firm publishes its reconstitution rules on its website, it's possible to take an educated guess as to who the "winners" will be ahead of time.

But can you profit by doing so? Vitaly Serbin, a director of Investment Technology Group Inc. in New York, and two of his colleagues wrote a May, 2011, paper that poses a question in its title: "Investing in Projected Russell 2000 Stock Additions: A Viable Investment Strategy or a Loser's Game?" They conclude it's the former.

Mr. Serbin and his colleagues developed a model to predict which stocks would be added, and tested the results of buying the predicted adds from 2005 to 2010, ahead of the annual June shakeup.

In general, the earlier the predictive portfolio was assembled, the better the results. The period of greatest success for the researchers started in the middle of April and ran into the middle of May, with portfolios returning approximately 3 per cent over three to four weeks – equivalent to a 36-per-cent annual return.

So, let's use the ITG predictive model! Unfortunately, it's "predictive" in a way that's only useful for an academic paper – it depends on a Monte Carlo simulation with uniform random numbers, et cetera.

Instead, an investor with a stock screener can play around with the Russell rules and come up with names that may merit a closer look. Attention to detail is required: Russell Investments excludes a host of structures, such as closed-end funds. It has a multistage test for whether a company really is based in the United States. And it sets minimums for share price and float.

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In 2011, it took a market capitalization of $130-million (U.S.) to make the Russell cut; the Russell 2000 is down about 3 per cent, year over year, so the cutoff point shouldn't be too far afield of that number.

A company that has zoomed well above the cutoff seems to be a highly likely inclusion, and there may not be much profit in buying the shares. There would be more risk, and more possible gain, for a company right around the cutoff. And companies that currently wouldn't make the cut — but are just a quick jump away from inclusion — may offer the best returns.

Some examples, which I offer without any recommendation as to their investing merits, other than the Russell 2000 factor:

-- XOMA Corp. , a Nasdaq-listed pharmaceutical company working on treatments for diabetes and cardiovascular disease, had a market cap of just $53-million in early March but has zoomed into Russell range with a value of about $175 million this week.

-- Galena Biopharma Inc. , a revenueless developer of cancer therapies, has a market cap of just under $100-million — but at $1.67, it's well off its 52-week high of $3.54 and had a borderline Russell market cap of $131-million as recently as March 21.

-- Hardinge Inc. , a machine-tool company, was on track to make the Russell last year with a market cap of $153-million on April 26; it stumbled by mid-June, dropping to $116-million, and missed the cut. It's at $111-million now, but its recent $9.56 price is also well off a 52-week high of $13.36.

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Note that this is a highly speculative strategy and not for long-term investors. It is, however, an intriguing opportunity to snap up some small U.S. companies before they hit the big time. Ideally, you can find companies that look attractive whether they enter the index or not.

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