In the world of small-cap companies, most don't get as much attention in the media or the blogosphere, which often leaves them less efficiently priced than their larger peers. As one can expect, hedge funds take advantage of this phenomenon by dedicating their research teams to work on these stocks, generating a significant portion of their alpha in the process.
Retail investors can use hedge funds' top small-cap picks as a market-beating strategy; we've determined that the most popular small-caps among hedge funds can earn about 120 basis points of alpha per month (check out the details here).
With this in mind, we're going to take a look at one fund in particular: John Paulson’s Paulson & Co. Paulson has a mammoth of an equity portfolio—about $12.7 billion in size—but let's focus on the fund manager’s five favorite small-cap picks (see all of Paulson & Co's stock picks). As is consistent with our strategy, each stock listed here had a market capitalization between $1 billion and $5 billion at the end of the third quarter.
At first glance, John Paulson would appear to be one hedge fund manager that retail investors should avoid. After all, he has gained quite the reputation over the past two years for returns that have his clients red in the face, that’s no argument. It’s crucial to point out, though, that these issues are predominantly the result of his large investments in mega-cap stocks, in addition to his macro views. Like David Einhorn (see Einhorn’s Huge Secret), Paulson’s smaller positions have performed very well historically, proving that it’s profitable to mimic these picks.
According to his latest 13F filing with the SEC, MetroPCS Communications Inc (NYSE:PCS) is John Paulson’s top small-cap holding, sitting at the No. 10 spot in his overall portfolio. MetroPCS is up over 47% in the past six months, and at first glance, these gains appear to have come from positive sentiment surrounding the company’s announced merger with T-Mobile USA. Since news of this deal broke on October 3rd of last year, however, shares of MetroPCS have actually lost 28.3%.
The deal, which is expected to close in the first half of this year, will gradually transfer customers from MetroPCS to T-Mobile, with the former’s network set for complete shutdown by 2015. The company is coming off of two consecutive colossal earnings beats, and reports its Q4 FY2012 financials at the end of next month.
At a PEG below 0.5 and 13 times year-ahead EPS, shares of MetroPCS are undoubtedly cheap, but with rumors of a bidding war between T-Mobile and Sprint still fresh, it’s possible some investors are uncertain what the future will hold. Still, at these levels, it’s hard not to mimic Paulson’s bullishness. Billionaires Steve Cohen and James Dinan are among the hedge fund managers who are bullish on PCS (see Steve Cohen’s stock picks).
AMC Networks Inc (NASDAQ:AMCX), the broadcasting and cable TV company, is Paulson’s second favorite small-cap, and is also a top pick of Christian Leone’s Luxor Capital. AMC Networks’ best asset is its original programming, which has generated double-digit viewership growth for shows like Breaking Bad and the Walking Dead, and the company is coming off a Q3 earnings beat more than 25% above Wall Street’s estimates.
How is the stock valued?