For investors, dot-coms near vanishing point

Investment company Frank Russell on Friday will release preliminary changes to its widely followed stock indexes for this year, and many dot-coms and related companies will be banished from the rankings.

That means those stocks will also fall off the radar screens of mutual funds that had about $175 billion tied to the performances of Russell's tallies at the end of the first quarter, including about $25 billion tracking the Russell 2000, generally considered the benchmark for small-cap stocks--that is, stocks of companies that are valued at under $600 million.

Russell's indexes cover the 3,000 largest stocks of publicly traded U.S. companies each year as of market close on May 31. The top third fall in the Russell 1000, and the rest are tracked in the Russell 2000. The final list becomes available July 1.

Last year's final list for the Russell 2000 includes at least 81 companies whose business models relied directly on the Internet. Those include content companies such as About.com, Internet retailers like 1-800-Flowers.com, online broker DLJdirect (now CSFBdirect), Internet service providers such as NetZero and consultants along the lines of Digitas.

Eight of those companies have already vanished from the Russell 2000 because of acquisitions or mergers. One deal announced Monday, UAL's purchase of Mypoints.com, will eliminate another Russell 2000 member.

Another 18 companies will be dropped from the small-cap index. Russell's criteria automatically excludes any stock whose shares closed below $1 on May 31, the date used by Russell for an annual snapshot of the market.

And several companies won't return to the list because their market capitalizations are too low.

On cushions and rock bottoms
Internet companies in the Russell 2000 have some institutional investment guaranteed because so many mutual funds are tied to the index. That cushion will disappear as of July 1 for any company that missed the cut on May 31, which is the most common reason for removal from the indexes, according to Paul Greenwood, senior research analyst with Frank Russell.

Over the last seven years, the lowest capitalization of the Russell indexes was $103.9 million in 1995. Although the minimum has since shot up, last year's minimum market cap of $177.9 million was actually down from a peak in 1998 of $221.9 million as initial public offerings flooded the market in 1999 and 2000, creating a new pool of smaller companies. According to Greenwood, more than 200 IPOs entered the Russell 2000 index last year. He expects fewer than half of that this year.

At the end of April, this year's cut-off point for Russell indexes looked to be about $130 million, give or take $10 million, Greenwood said. Should that level hold, at least 27 Internet-related companies are going to be out; and Russell indexers won't have to own the likes of Sportsline.com, MarketWatch.com, Juno Online Services, Net Perceptions, Geoworks, DSL.net, Ask Jeeves, Agency.com or E-Loan.

The cut companies will be replaced by other technology or Internet-related firms that fall out of the large-cap Russell 1000, particularly the would-be young lions that shot directly into the top segment last year from nowhere.

Greenwood estimates about 100 companies will move from the 1000 to the 2000. Prudential Securities estimates the technology portion of the Russell 1000 will fall to 17 percent from 18 percent last year.

Stock prices
Don't expect a major change in stock prices when Friday's preliminary report comes out, or when the final list goes into effect. In fact, a Prudential study of the Russell indexes indicated that last year's deleted stocks--384 companies, according to Russell--actually rose immediately after the annual changes to the index.

"Investors have become so savvy about the rebalancing that by the time the rebalancing takes place, much of the trading has already been done," said Ed Keon, director of quantitative research for Prudential Securities.

Anticipating changes in the Russell indexes has become a standard practice on Wall Street. "Over the last few years, there's been a cottage industry that's risen up around forecasting the annual reconstruction," Greenwood said.

Some observers want Russell to revisit its lists more often, to more closely mirror the market. In fact, Russell used to balance its indexes every quarter before making it a twice-yearly change and then an annual change in recent years.

Russell's data indicates that rebalancing once a year reflects the market's performance as accurately as the more frequent schedules do, Greenwood said. And doing it once a year reduces wild swings.

When the indexes were updated quarterly, "you'd have these stocks going in and out and in and out, and it would get frustrating," Greenwood said. "You end up increasing turnover with minimal benefits as to how accurate the index is."

And higher volatility is the last thing a suffering dot-com company needs.