We have read dozens of articles about hedge funds and hedge fund advertising over the last few weeks. None of them were 100% accurate and most of them were filled with inaccuracies. The number one mistake they made was comparing hedge fund returns to 100% long S&P 500 index. Hedge funds are almost always hedged and in some cases their market exposure can be negative. You shouldn’t be surprised that S&P 500 index is beating hedge funds in bull markets. The same way that you shouldn’t be surprised that the weather is extremely pleasant in Buffalo during summer months. You can predict when the winter is coming to Buffalo and avoid it. Unfortunately you can’t say the same thing about the S&P 500 index. It is 100% long no matter what happens.
Historically hedge funds’ long stock picks did beat the market significantly. They are great at picking winners. To demonstrate this fact and help our readers beat the market we started sharing the most popular small-cap stocks among hedge funds at the end of August 2012. These are stocks with market values between $1 billion and $5 billion, and they are the consensus picks of dozens of prominent hedge funds. Over the last 11 months this simple strategy returned 55.9%, vs. 22.5% gain for the SPDR S&P 500 ETF Trust (NYSEARCA:SPY). We also backtested this strategy and it managed to outperform the S&P 500 index by 18 percentage points per year between 1999 and 2009 (see the details).
The second mistake financial media made was claiming that it isn’t possible to pick the best hedge fund managers. We may not be able to pick the better fund manager between two randomly picked hedge fund managers but we will know when we meet a great hedge fund manager. The same phenomenon exists in sports. You may not be able to pick the better football player between two randomly picked players but you know that Brett Favre or Tom Brady are among the best players. Four months ago we published an article on Marketwatch with the title “3 stock picks from the next David Einhorn” and shared the stock picks of Michael Castor. Yeah, we know you never heard of Michael Castor before. Castor’s first pick, Cardinal Health Inc (NYSE:CAH) returned 21.3% since we published that article. Castor’s second pick, NPS Pharmaceuticals, Inc. (NASDAQ:NPSP), gained 77%. S&P 500 ETF’s 8.5% return during the same period barely outperformed Castor’s third pick Anacor Pharmaceuticals Inc (NASDAQ:ANAC)’s 7.1% gain. Castor’s three picks averaged more than 35% in four months.
In this article we will share 3 stock picks by another great hedge fund manager, David Simon of Twin Capital, who demonstrated that he can generate an annual alpha of around 7 percentage points per year. Twin Capital’s annual returns ranged between 6.5% and 13.2% between 2008 and 2012. This means David Simon underperformed the market during most of this period yet managed to deliver a cumulative return of 53.4% vs. a gain of 8.6% for the S&P 500 index during the same period. How is this possible? Because he is hedged and he can deliver alpha, David Simon managed to return 6.5% in 2008 when most of retirees’ 401ks turned into 201ks.
Last month we sat down with David Simon and asked him about his best investment ideas. Here is what he said:
“I think one of our best investment ideas is a triple net lease real estate investment trust called American Realty Capital Properties Inc (NASDAQ:ARCP). The symbol is American Realty Capital Properties Inc (NASDAQ:ARCP), and it’s yielding about 6.4% right now. They’ve done a lot of acquisitions lately, and they’ve grown from a market cap of 140 million to about 5 to 6 billion in the next three months. This is all this year. Their dividend right now is at $0.91, I think, and on October 1st, it goes to $0.94. We have it going to well over $1 next year.
There’s one acquisition that’s pending a go shop period which we believe will not be a problem. They’ve already issued stock to finance that acquisition plus another acquisition from GE Capital of QSR triple net properties. Then we believe there’s one more acquisition on the back burner for October or November.
Once all these acquisitions are done, based on if they could still finance where we think they could finance 7-year paper, we think it’s accretive to the tune of about 25% to 35% to next year’s funds from operations. We think they’ll grow their dividends at half the rate of FFO. So, they should grow the dividend at least 15%. It should go from about $0.94 to at least $1.08. So, at $1.08, you’re talking about – based on what the stock price is now – well over a 7% yield.”