The reconstitution of the Russell indexes takes place annually, at the midpoint of the year. Bank stocks are added to and deleted from the index based primarily on market capitalization thresholds that vary from year-to-year due to stock price movements and M&A activity. Many investment funds are indexed to the Russell and are thus required to buy or sell stocks on a formulaic basis upon reconstitution every year. In advance of the actual event, other market participants attempt to anticipate the results of the reconstitution. This dynamic can materially impact stock prices for several months before and after reconstitution and, within that period of time, can sometimes overwhelm all other variables that typically drive movements in share price.
There are several investment banking firms that have teams dedicated to predicting and analyzing the Russell reconstitution and those firms are much better suited to addressing the specifics of how the process works. That said, I do have a couple of anecdotal observations that I think could make this year’s Russell event potentially more consequential than in prior years.
- First, and most simply, the stocks are up significantly from last year’s reconstitution. The minimum market cap threshold last year was $95 mil., and most estimates I’ve seen suggest the cut-off for this year could be $200 mil. or higher. With the recovery in bank stock prices having lagged that of many other sectors over the past year, the number of bank stocks subject to deletion from the index is likely to be higher than normal.
- Second, there has been virtually no M&A activity since the last reconstitution, which means that there are not as many spots opening up as a result of banks in the index having been acquired, further compounding the issue noted above.
The implications of the Russell trade this year are already noticeable, likely leading to challenges for some banks and opportunities for others, while presenting a conundrum for investors in terms of how to play it.
In terms of stock price performance year-to-date, the evidence is pretty stark. For instance, bank stocks that are currently in the Russell but are less than $200 mil. market cap (and thus at risk for deletion based on current projections) are down 1% year-to-date (as of Feb. 1) compared to a 13% increase in the KRE over that same period. It’s also worth pointing out that the further a company’s market cap is from the $200 mil. projected minimum threshold, the greater the underperformance. Indeed, stocks below $150 mil. market cap are down 2% YTD, stocks below $125 mil. are down 3%, and certain individual stocks are down in the double digits on a percentage basis.
I think the evidence is sufficient to conclude that the Russell dynamic has been the primary driver of stock price underperformance year-to-date for this subset of banks. If so, there are some intriguing potential ramifications, particularly if one assumes that bank stocks, generally speaking, will continue to move higher over the course of this year, the Russell names continue to lag into the reconstitution, and the pace of M&A activity picks up.
- Impacted Company Perspective For affected companies that might have been considering a sale over the next 12-18 months, will plans get accelerated? Will this acceleration, in turn, avoid further degradation of relative value into the reconstitution and the time it might take thereafter for valuation to rebound to a level that fundamentals and franchise value might otherwise imply?
- Acquirer Perspective On the flip side, does a savvy acquirer – provided they are comfortable with the risk profile of the target – approach a company impacted by Russell reconstitution and offer a potential way out? Perhaps a deal at a reasonable price (but still favorable for the acquirer) that partially accounts for the Russell-induced valuation impairment, with an opportunity for the target to ride the acquirer’s share price to post-COVID recovery?
- Investor Perspective The conundrum for investors is equally as intriguing. Do investors accumulate shares now in companies that have already been impacted by the Russell trade at what appear to be attractive absolute and relative valuation levels? This, with the caveat being that valuation enhancement in the near-term will lag the continued improvement in the broader peer group? Or will these stocks continue to materially underperform, thus making them companies to avoid for the foreseeable future? This may be true particularly if one subscribes to the notion that bank stocks in general are likely to continue marching higher in the coming months.
Closing Thought
These questions are likely to be at the forefront of the conversation amongst community banks, investment bankers, and investors over the coming months. My best guess is that we will see a selective acceleration (but not a tidal wave) of M&A in advance of Russell reconstitution. Setting the M&A dynamic aside, I suspect that share prices of impacted Russell names could remain under pressure in the near-term. Amidst a likely continued rising tide for bank stocks in general or given, in some cases, record-low absolute valuation levels coupled with stabilized-to-improving fundamental trends for the vast majority of impacted companies, share prices could catch a bid – perhaps even in advance of reconstitution. Regardless, this dynamic will be interesting to watch over the next several months.
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