How Did Hedge Funds’ Top Small Cap Picks Do?

Hedge funds spend lots of money hiring bright people to do exhaustive research on a broad universe of stocks- not just the megacaps that dominate financial journalism. The research may not be public, but to some extent the results are. Six to seven weeks after the end of every quarter, hedge funds and other major investors report many of their long equity positions in 13F filings. Can this delayed data be useful to investors? In June, we detailed hedge funds’ six favorite stocks with market caps between $1 billion and $4 billion (read our original article). Here’s how five of those stocks have done since then (Solutia, another of the top picks, has been acquired):

Ken Griffin CITADEL INVESTMENT GROUP

American Eagle Outfitters (NYSE:AEO), which was the favorite stock in this valuation range, is up 10.4% since we published our article on June 6th. These days it seems to be a more popular sell than buy among hedge funds; while billionaire Ken Griffin’s Citadel Investment group owned the stock at the end of September, it had cut its stake by about a third over the course of the quarter (see what stocks Citadel is buying instead). American Eagle trades at 24 times trailing earnings, and doesn’t seem to be growing its net income much.

Abercrombie & Fitch Co. (NYSE:ANF) is up 37.3% since our article was published, and we actually reported recently that Citadel had bought up 6.3% of the total shares outstanding (learn more about billionaire Ken Griffin buying Abercrombie & Fitch). The stock is expensive on a trailing earnings basis, but its earnings were up 41% in its most recent quarter compared to the same period in the previous year and it trades at only 13 times forward earnings estimates.

Walter Energy, Inc. (NYSE:WLT) was a big miss on the part of hedge funds, as the miner (which focuses on metallurgical coal) is down 37.8% in less than six months. It’s unprofitable on a trailing basis, though there seems to be some optimism in the financial community as it is expected to break back into profitability next year. Renaissance Technologies, whose founder Jim Simons is now a billionaire, bought the stock during the third quarter and owned 1.6 million shares at the beginning of October (check out more of Renaissance’s stock picks).

United Rentals, Inc. (NYSE:URI), meanwhile has been a good performer, up 26.5%. This is a furiously contested stock: 15% of the float is held short, as traders eye how exposed the construction and industrial equipment rental company is to the broader economy (the beta is 3). On the other hand, revenue and earnings are up and analysts expect continued growth in 2013 as the forward P/E multiple is only 8. Billionaire James Dinan’s York Capital reduced its stake by 55% during the third quarter (find more stocks that Dinan has been buying or selling).

Visteon Corporation (NYSE:VC) has matched United Rentals’ performance with a 28% gain since early June. The company produces auto parts such as climate and entertainment systems. Billionaire Steven Cohen’s SAC Capital Advisors liked the stock, with its 2.6 million shares at the end of September being a 42% increase over what it had owned at the beginning of July (see more of Steve Cohen’s favorite stocks). We would note that while the stock has been doing well earnings dropped 63% in the third quarter versus a year earlier.

On average, these five stocks are up an average of 12.8% in the last 5-6 months, outperforming the S&P 500 index ETF (SPY) which has gained 8.2%. Hedge funds’ most popular small cap picks performed even better than the Russell 2000 index ETF (IWM) which gained only 6.2%. Now, this is only one “experiment” and doesn’t prove that following hedge funds’ small cap picks will always (or even on average) beat the market, especially since one of their favorites has done so poorly in the last several months. However, our research shows that historically these stocks have beaten the market by more than 10 percentage points annually (read more about our strategy). We’ve recently processed the 13Fs for the third quarter of 2012 and the most recent list of small cap picks can be found in our newsletter.

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