The Small-Cap Shake-Up That Drives Big Gains

Editor's note: It's hard to outperform in a market where everyone is chasing the same stocks. But according to Joel Litman, chief investment officer of our corporate affiliate Altimetry, not every corner of the market is so efficient. In this issue, adapted from this month's issue of Microcap Confidential, Joel explains how investors should prepare for "reconstitution day" – when overlooked small caps can quickly become must-own stocks...

Beating the market is hard.

Over the past 10 years, just 14% of U.S. large-cap funds have outperformed the S&P 500 Index.

Every day, more than 16 billion shares trade across the New York Stock Exchange and the Nasdaq. That's millions of people, buying and selling hundreds of billions of dollars' worth of stocks daily.

Folks around the world compile their insights and analyses to create consensus prices for companies. The bigger the company, the more investors research and trade the stock... and the more likely it is that it's fairly valued.

That makes big upside hard to come by. It's hard to impress investors who already expected strong results.

It's an efficient, time-tested system. This is why it's so hard to beat the market.

But that's only part of the market.

Analysts at major funds mostly focus on the biggest companies, like those in the S&P 500. But thousands of other great companies are overlooked and undervalued.

And that's where the opportunity lies...

We're approaching the best opportunity of the year to invest in small-cap stocks... and trounce the market in the process.

It's called "reconstitution day."

The S&P 500 only tracks the biggest stocks in the market. The Russell 2000 Index, on the other hand, tracks the 2,000 best small-cap U.S. stocks. And on June 26, the Russell 2000 has its biannual update.

How Rebalancing Creates Instant Demand

When a company gets added to this index, it sees a wave of new purchase orders... often accompanied by a rising stock price.

You see, institutional investors need to own the stocks in the Russell 2000 to track the index's performance. So when a stock is added, it suddenly gets a ton of new buyers.

(And the opposite is also true. Stocks that get removed often see heavy selling as funds match the index.)

Reconstitution day puts great, overlooked businesses in the spotlight... often for the first time. When these stocks start to get the recognition they deserve, shareholders profit.

The key is getting in early... because the biggest gains don't happen on reconstitution day itself. They happen in the weeks leading up to it – when the market starts to figure out which companies will likely be added.

That process begins on "Rank Day," which falls on April 30 this year.

This is when the folks at FTSE Russell rank every eligible U.S. stock by total market cap. The largest 3,000 make the Russell 3000. The smallest 2,000 of those become the Russell 2000.

At last year's reconstitution, the smallest company in the index had a market cap of $119 million. Any company trading on a major U.S. exchange... with a large enough market cap... and enough daily trading volume... is a candidate.

Just take industrial company Power Solutions (PSIX). Back in 2021, it generated a paltry negative 16% Uniform return on assets ("ROA"). At Altimetry, we analyze earnings with Uniform Accounting to avoid the distortions of traditional accounting methods.

Over the next three years, returns climbed. They reached 24% in 2024 – double the corporate average.

This was a bad business that quickly became great. But it wasn't until last year that most professional investors started to take a closer look... after Power Solutions was added to the Russell 2000 on reconstitution day.

Shares are up 240% over the past year. That's 10 times better than the S&P 500's gain in the same time frame.

Act Before These Stocks Get Discovered

And this isn't a one-off. Twenty-one stocks added in last year's update have doubled in the past year.

Reconstitution day is a huge opportunity for companies that have been overlooked for years... But they won't stay cheap for long.

That means we have to move fast.

If you have the tools to do this ranking yourself, you can get a pretty good idea of which stocks will be added this year (barring any major market-cap surprises).

Of course, most folks outside of Wall Street can't do this. It requires sorting through thousands of companies... estimating market caps... and identifying who may be included.

But that's where the edge comes from.

The market is efficient at the top. But it's far less efficient in the small-cap space – especially around events like this.

If you want to beat the market, you have to look where others aren't. Right now, that means small-cap stocks on the verge of being added to the Russell 2000.

Over the next few weeks, those overlooked names can quickly become must-own stocks.

And by the time everyone else catches on, the easy gains are already gone.

Good investing,

Joel Litman

Editor's note: Reconstitution day is one of Wall Street's most consistent opportunities. It's a mandated reset that has historically driven huge stock moves. Last year alone, it led to 21 doubles and multiple triple-digit winners. With this year's event approaching fast, learn how to position yourself ahead of Wall Street's biggest firms.