Small and mid-cap stocks don’t get as much attention from analysts and the financial press, which often leaves them less efficiently priced than the large and mega-caps. Hedge funds sometimes take advantage of this by dedicating their research teams to work on these stocks as well, and so often earn substantial alpha from their investments.
Retail investors can use hedge funds’ top small-caps as a screening device; we’ve determined that the most popular small-cap stocks among hedge funds can earn about 120 basis points of alpha per month. We started publishing a quarterly newsletter at the end of August and shared the stock picks of this strategy. Since then, this strategy returned 14.3% (through December) vs. 2.1% for the S&P 500 index (learn more about our hedge fund small cap strategy).
Two of Bacon’s top small-cap stock picks are in the financial services field. Assured Guaranty Ltd. (NYSE:AGO) is Bacon’s top small-cap pick and is also his 13th largest 13F holding. The Bermuda-based holding company provides credit enhancement products to the municipal finance and mortgage markets. Assured has performed well lately, beating analysts’ earnings estimates each of the last four quarters and is expected to grow 5-year EPS at 12% annually.
This outperformance has helped its stock beat other major bond insurer MBIA by 37 percentage points over the last twelve months. Billionaire Jim Simons is one of the top-name investors in Assured (check out Jim Simons’ top picks).
Alterra Capital Holdings Ltd (NASDAQ:ALTE), meanwhile, is Bacon’s other financial services pick and is his third largest small-cap position. Alterra provides diversified specialty insurance and reinsurance products to corporations, public entities and property/casualty insurers.
Alterra is trading higher on the news that Markel would buy the company for close to $3 billion in cash and stock. Following the news, Deutsche downgraded the stock and placed a $29 price target on it – shares currently trade around $29.50. On the bright side, both financial services investments do offer investors a dividend; Assured pays a 2.4% yield and Alterra pays a 2.2% yield. Billionaire Ken Griffin – founder of Citadel Investment Group – is the top fund owner of those we track with 6.9 million Alterra shares (check out Ken Griffin’s newest picks).
What are Bacon’s other small-cap picks?
Two of Bacon’s other top five small-cap picks are in the oil and gas industry: Oasis Petroleum Inc. (NYSE:OAS), its second largest small-cap holding, and Kodiak Oil & Gas Corp (NYSE:KOG), its fourth largest. With both trading below a $5 billion market cap, either could be a potential takeover target.
Both stocks trade at outsized P/E ratios when compared to peers. Oasis is at a 33x P/E and Kodiak trades at 42x earnings, compared to Apache (13x) and Warren Resources (15x). Oasis and Kodiak’s impressive growth rates appear to justify their high valuations. With very strong expected 5-year earnings expansion of 35% annually, Oasis appears to be a cheap growth stock with a forward PEG 0.66.
Its peer Kodiak, however, appears to be an even better deal, with a PEG of 0.4 on a 50% expected long-term earnings growth rate. These two oil and gas companies operate in the high profile mid-continent area, and should be driven higher by increased demand for oil and gas on the back of a rebounding economy. Ken Griffin and Steven Cohen both increased their stake in Oasis over 100% in their latest 13F filings (check out Steve Cohen’s top picks).
GNC Holdings Inc (NYSE:GNC), the nutritional supplement retailer, is Bacon’s fifth largest small-cap holding. Momentum has been solid for the stock as consumer spending for health products and supplements have held up despite a less than stellar economic backdrop. The stock is up 31% over the last twelve months and FY2012 earnings are expected to come in 50% above FY2011. The introduction of new products and marketing initiatives should be a big part of the nutrition company’s expected near term growth. Compared to other major nutrition supplement provider Vitamin Shoppe, GNC is cheap. GNC trades at a P/E of 17x, while Vitamin is at 28x. With GNC’s low P/E and high long-term growth rate of 22%, its PEG comes in at only 0.7.
To recap: The majority of hedge funds’ alpha is derived from investing in small-cap stocks, and by outlining billionaire Louis Bacon’s top five small-cap stocks we hope to give retail investors a starting point for generating their own alpha. Two of Cooperman’s small-cap picks are in the financial services industry, but pay investors modest dividends. Two stocks are in the oil and gas industry and could be possible takeover candidates, and its final pick, GNC, is a growth at a reasonable price opportunity.
Read more about Louis Bacon’s picks:
Louis Bacon and Jim Cramer Like AIG, Wells Fargo, and More
Billionaire Bacon’s Energy Picks
News Corp, Dollar General Are Among Bacon’s Bullish Bets
Disclosure: I have no positions in any of the stocks mentioned in this article
