5 Stock Picks from Gates Capital Management

Jeffrey Gates founded Gates Capital Management in 1996 after a career researching and selling high-yield bonds and currently serves as the fund’s portfolio manager. Gates, which is based in New York, is an event-driven investor who seeks to identify “dislocation events” at public companies which are creating cash flow and sustainable value. It expresses its views through both debt and equity investments. See our list of stocks Gates Capital Management owned at the end of the second quarter of 2012 according to what it disclosed on its 13F filing with the SEC or read on for analysis of five of the fund’s top holdings.

The fund’s largest position according to 13F filings was Nortek Inc (NASDAQ:NTK), as Gates reported owning 2 million shares at the end of June. Nortek provides building products such as ventilation devices (including kitchen range hoods and air exchangers), audio/video equipment, and air conditioners. Nortek IPOd in November 2011 and has been doing quite a bit better than certain other recent IPOs: the stock is up 159% in the 10 months since the company went public. However, this rise in the price may have outpaced Nortek’s business as it now trades at 56 times trailing earnings. Joel Greenblatt initiated a position in Nortek during the second quarter.

GOTHAM ASSET MANAGEMENT

Another of Gates’s top picks was tool and diagnostics device company Snap-on Incorporated (NYSE:SNA). The fund increased its position by 26% during the second quarter to a total of 1.4 million shares. Snap-On’s recent performance hasn’t been quite as good as Nortek’s, but the stock is still up about 60% over the last year (easily beating the broader market) despite the fact that its revenue and earnings are tracking about the same as a year ago. Snap-On trades at a trailing P/E multiple of 15 and a forward P/E multiple of 13, and so may still be a good value.

Darling International Inc. (NYSE:DAR) is a $2.1 billion market cap company which renders animal remains and cooking oil into food recovery products and also processes excess baked goods into animal feed. Despite the growth of the restaurant industry, Darling saw a 7% decline in revenue and a 31% drop in earnings in the second quarter compared to the same period in the previous year. Gates increased its stake in the company by 54% compared to the end of March and now owns 5.4 million shares; the fund may be attracted to Darling’s attractive valuation metrics as the stock trades at 16 times trailing earnings and only 12 times forward earnings estimates. We think investors could look at this stock more closely.

DaVita Inc. (NYSE:DVA) picked up a lot of interest from notable investors last quarter according to our 13F database; Warren Buffett’s Berkshire Hathaway increased its own position by 55% (find more stocks Buffett has been buying). Gates got there early: it actually slightly reduced its holdings in the second quarter, though it still closed June with about 810,000 shares in its portfolio. DaVita operates dialysis centers for patients whose kidneys are failing. It is also a borderline value stock with both its trailing and forward earnings multiples in the teens.

Gates reported 1.6 million shares of The McGraw-Hill Companies Inc. (NYSE:MHP) in its portfolio, which represented a 77% increase from the end of the first quarter. McGraw-Hill, which also owns the Standard & Poor’s business of providing credit ratings and financial research products, had about flat performance for its business last quarter versus a year ago. The company plans to split in two in the next several months, allowing its education and financial products to operate independently. McGraw-Hill is valued at $15.3 billion, which represents a trailing P/E multiple of 17.

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