Smaller cap stocks don't get as much attention from bankers, analysts, and most other investors. Generally speaking, this leaves them less-efficiently priced than their larger peers. Hedge funds take advantage of this by dedicating their research teams to work on the little guys, and consequently, they produce a significant amount of their alpha from the small-caps. According to our analysis, investing in the smart money’s top small-cap picks has generated an annual alpha of more than 15 percentage points per month between 1999 and 2009 (learn more about this phenomenon here).
Let's take a look at the top small-cap stock picks of one hedge fund in particular: Roberto Mignone’s Bridger Management. The stocks listed here had market capitalizations between $1 billion and $5 billion at the end of the third quarter, which is consistent with the criterion used in our strategy (see all of Roberto Mignone's stock picks).
Assured Guaranty Ltd. (NYSE:AGO) is Mignone’s top small-cap holding, sitting at the No. 5 spot in his latest 13F filing with the SEC. Assured Guaranty’s subsidiaries offer a range of credit-related services to infrastructure projects, state governments and utility districts. Shares of the insurer are up more than 25% on the year, and it will report its fourth quarter earnings in close to a month. Assured Guaranty is coming off of two consecutive EPS beats by an average margin of 12.2%. A PEG ratio near 0.5 and a forward earnings valuation under 7x indicates that investors could see more upside if the company can impress with Q4 results. It’s tough to argue with Mignone here.
The fund manager’s second largest small-cap investment is Tripadvisor Inc (NASDAQ:TRIP). Shares of the online travel site have been a great investment over the past 12 months, returning a little over 45% in value. While Tripadvisor looks a little overvalued at the moment, the sell-side is expecting bottom line growth in excess of 20% annually over the next two years, so there are reasons for momentum-seeking investors to remain bullish. Over the long, long run, Tripadvisor has Google problems, as the tech giant’s acquisition of ITA Software gives it a greater foothold in this space. Still, for those focused on the shorter term, Tripadvisor offers solid growth.
Who's the best of the rest?
Avis Budget Group (NASDAQ:CAR) is Mignone’s third largest small-cap holding, sitting at the No. 15 spot in his entire portfolio. Avis has been a booming investment over the past 3-month (32.7%), 6-month (47.0%) and 12-month (48.7%) periods, indicating that investors are using the stock to buy in on the bullish car rental marketplace. Avis announced it would acquire car-sharing service Zipcar earlier in January, and assuming that anti-trust regulators don’t put a stop to the deal, it should be completed by this spring.
Avis’ earnings currently trade at a 13% discount to the rental industry’s average, and Wall Street expects accelerating EPS growth over the next half-decade. Analysts predict 29.7% annual growth compared to Avis’ 13.9% average over the past five years.
Charles River Laboratories (NYSE:CRL), meanwhile, is Mignone’s fourth favorite small-cap stock, and is already up more than 10% year-to-date. The biotech company wasupgraded to overperform by JPMorgan and Wells Fargo at the end of last year, and it recently completed its acquisition of majority ownership of Vital River, a Chinese research model servicer. Charles River has beaten the Street’s earnings forecasts in four consecutive quarters, and reports its fiscal Q4 results about two weeks from now. If the company can meet or beat the sell-side’s 60-cent EPS and $281 million revenue estimates, shares could appreciate further. Charles River currently trades at a modest 14.5 times forward EPS, which is below peers Life Technologies and Idexx Labs by an average discount of 31%.
Last but certainly not least, Ironwood Pharmaceuticals (NASDAQ:IRWD) is Roberto Mignone and Bridger Management’s fifth largest small-cap holding, sitting at the No. 23 spot in the fund’s 13F portfolio. Ironwood may be best known for its drug Linzess, which is prescribed to those suffering from chronic constipation and irritable bowel syndrome. Some analysts think Ironwood’s drug can become a billion-dollar-a-year giant (see Will This Drug Be a Cash Cow?), and the company did report a blowout third quarter in its latest earnings.
A couple weeks ago, the stock saw major downgrades from UBS, Zacks and TheStreet, but Mizuho, WallachBeth and Ladenburg Thalmann raised their price targets. Still, at elevated price-to-sales (9.3x) and book (9.7x) multiples, it may be best for investors to find a more attractive entry point into Ironwood.
Disclosure: I have no positions in any of the stocks mentioned above