In recent posts, I’ve written about the disappearing abnormal returns for additions to the S&P Index and the significant outperformance of S&P deletions after the effective date.

To finish off the series, I’d like to catch up with several recent developments around these trading strategies and examine if the same abnormalities would hold for other indexes as well (namely the Russell 2000 Index).

But first, I’d like to point out some changes related to the S&P indexes…

S&P Discontinues Announcements

Standard & Poors posts news and announcements regarding the various indexes on their website.

Each announcement can be saved as a .pdf file, but the website does not provide an RSS feed for staying up to date.

During the research for my previous posts, I was able to sign up for S&P’s email list in order to receive timely announcements regarding additions and deletions, without having to check the website each day.

Sadly, I received an email on August 3rd announcing that Standard & Poors will be discontinuing their email list:

“S&P is implementing a new policy that will affect email alert communications in relation to index announcements and other index-related matters. Effective August 13, 2010, S&P will provide email alert communications only to subscribers.”

Unfortunately, subscription is not cheap.

Recent Additions

Since my original post, Standard & Poors has announced several changes to the indexes.

On July 8, S&P announced that ACE would replace MIL in the S&P 500 index on July 14.

Results:

• Price on AD + 1 – $54.69
• Price on ED – $55.88
• Outperformance – 0.81%

In addition, two other stocks were added to the S&P Smallcap 600 index on July 8 (ODSY & SXE) for those who would like to continue following this strategy.

Recent Deletions

On June 23, S&P announced that MAG would be replaced by FSS in the S&P Smallcap 600 index due to market cap considerations.

Results:

• Price on ED – $0.92
• Price on ED +20 – $1.09
• Outperformance – 12.22%

The deletions strategy continues to outperform.

Russell Index

A reader comment asked whether the trading strategies detailed in my original posts would also apply to the Russell 2000 index.

While the S&P 500 index is widely used as the “benchmark” for large-cap mutual funds, many small-cap funds compare their returns to the Russell 2000, the bottom 2000 stocks in the Russell 3000 Index.

Russell Reconstitution

As opposed to the S&P index – where stocks are picked subjectively by committee on an as-needed basis throughout the year – stocks are added to the Russell Index using strict rules based on market capitalization.

Rather than replacing stocks throughout the year, the Russell Index is rebalanced once a year during the month of June – an event known as reconstitution – with a preliminary list of additions and deletions announced two weeks in advance.

In 2010, a preliminary list of stocks was announced on June 11, with an official reconstitution date of June 25.

Just like the S&P effect, index funds following the Russell 2000 are required to closely match the index returns – meaning managers must buy and sell indiscriminately around the reconstitution date.

Returns

Academic studies have shown stocks added or deleted to the Russell 2000 show statistically significant returns during the reconstitution period.

In 2010, there were 333 additions and 219 deletions. I calculated average returns below.

Results:

• Additions: 1.23%
• Deletions: -1.90%

This compares to a loss of -0.36% to the underlying index.

Conclusion

Based on these results, there seems to be an opportunity for investors to profit from this annual re-balancing.

However, there are certainly challenges:

• The sheer volume of changes could make a profitable trading strategy hard to implement.
• Differences between the preliminary and final list could leave investors holding stocks that did not make the final cut.
• Several changes to the reconstitution method – including market cap banding and adding IPO stocks on a quarterly basis – have decreased the abnormal returns.

Even with these considerations, there is evidence that the Russell 2000, just like the S&P indexes, experiences an index effect that drags on investment returns.

One study (co-authored by Vijay Singal, the author and inspiration for my previous posts) found that the Russell 2000:

“underperformed other small-cap indexes by more than 3 percentage points a year in the 1995-2002 period, even though comparable indexes did not entail more risk.”

Disclosure

No position in any of these stock at the time of this writing.

NOOF reported first quarter earnings this past week, and turned in a solidly profitable quarter, after suffering through two write-down plagued years.

Financial Highlights

Revenues were flat compared to the same quarter last year, coming in at approximately $12.5m. Margins took a hit, primarily due to higher costs in the Film Production segment, causing net income to fall 33%.

It was an unusual quarter from a cash flow basis, as NOOF actually used cash in operating activities.

As opposed to its traditional TV business, the company pays for the upfront costs in its Film Production segment, only to recoup the money later once the finished product is delivered.

Under this arrangement, the company has approx. $5.3m in cash that should be collected in the next few quarters.

While this strategy entails risk (NOOF might have to absorb the costs if the end customer doesn’t end up paying), the company’s balance sheet is very strong, with $14.1m of cash on hand along with an unused $4m credit line.

Domestic Growth?

Domestic sales – still the vast majority of NOOF’s revenues – are still showing the effects of the economic downturn. However, the company seems to be working hard to address these challenges by testing new initiatives in several test markets.

According to the CEO,

“We believe these results indicate that improvements in category results are achievable. If operators choose to roll-out these new products across their platforms and do so quickly, our financial results could benefit on both a near-term and long-term basis.”

International Growth Opportunity

For future prospects, the international market holds the key to NOOF’s future.

For the quarter, international revenue doubled in the Transactional TV segment, and on August 3rd, the company announced that it entered into a five-year license agreement to rebrand and distributed three new channels throughout Europe, the Middle East, and areas of Northern Africa.

The new channels are expected to reach over 49 million unique homes and are an entirely new revenue opportunity.

Even better, there is much less consolidation internationally among operators. According to the CFO, NOOF can expect much higher margins with these agreements as compared to the domestic market (30-50% as compared to 10-15% domestically).

Institutional and Insider Ownership

During the quarter, NOOF also filed its DEF14A for the year.

The stock remains popular with several institutional firms and hedge funds, with several investors holding a large stake in the business.

While several funds have trimmed their holdings slightly over the past year, a brand new investor – Robeco Investment Management – picked up a 7.6% stake.

In addition, company insiders have increased their ownership in the business to 10.3%, an increase of 2.6%.

Increased ownership by both investment management firms and insiders is an encouraging sign, as other investors (and insiders!) believe the company’s prospects are positive going forward

Conclusion

By most any measure, the stock remains extraordinary cheap:

• Price/Sales – 0.62
• Price/Book – 0.60
• Forward P/E – 5.4

Although some might argue that long-term prospects for the business are challenging, NOOF certainly has big plans:

“we expect to increase our distribution to over 300 million worldwide network homes, representing an increase of approximately 40% over our current distribution.”

With hoards of cash, a solid balance sheet, and potential growth both domestically and internationally, NOOF should increase from its current lows.

Disclosure

Long NOOF

Recently, I’ve written two posts detailing trading strategies for taking advantage of the S&P index effect.

S&P Additions

The first post described a trading strategy for S&P additions. Although it was a profitable strategy over the past few decades, the effect seems to be shrinking.

S&P Deletions

The second part of the series focused on S&P deletions.  The stocks in my sample from the past two years generated outstanding returns, substantially outperforming the broader market.

Trading on deletions is intriguing, since it is very similar to the proven value investing strategy around stock spinoffs.

In summary, indiscriminate selling by index funds provides an opportunity for smart investors to buy stocks selling at a large, but temporary, discount to their true value.

Featured on ZeccoPulse

I was surprised and honored to find my posts featured at Zecco.com. In a post entitled, “The Index Effect: Potential Trading Opportunities?”, Richard Bloch, the Sr. Editor at ZeccoPulse, used my research for a discussion around trading opportunities between S&P indexes.

I thought this was a great quote for summing up why the strategy works:

“If you’re not so fussy about artificial market cap criteria, then it probably doesn’t make much of a difference whether a company’s market cap rank is 498 or 502 – or whether its rank is 897 versus 901 – as long as the fundamentals and technicals still make sense to you.”

Stay tuned for part 3 of the series next week!