Generally speaking, small-cap stocks don’t receive as much coverage from analysts and the media, which often leaves them less efficiently priced than their larger peers. Hedge funds, meanwhile, choose to take advantage of this by dedicating their research teams to work on the small-cap space, generating a significant portion of their alpha in the process.
In fact, retail investors can use hedge funds’ top small-caps as a market-beating strategy. At Insider Monkey, 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 since then, until the end of December, this strategy returned 14.3% vs. 2.1% for the S&P 500 index (learn more about our hedge fund small cap strategy).
Keeping this in mind, we’re going to take a look at one fund in particular: Kris Kristynik’s Longhorn Capital. Kristynik is a member of the famed “Tiger Cub” club, and manages a relatively small 10-stock equity portfolio (see all of Kristynik’s holdings here), two of which are small-cap stocks. In the spirit of our market-beating strategy, we’ll discuss them here. Each had a market capitalization between $1 billion and $5 billion at the end of the third quarter.
According to Kristynik’s latest 13F filing with the SEC, Cash America International, Inc. (NYSE:CSH) is the hedge fund manager’s top small-cap holding, sitting at the No. 8 spot in his overall portfolio. Cash America has been a great investment over the past six months, up close to 30%, and momentum has been rather strong since the start of the New Year.
The company offers pawn and payday advance loans, and has seen annual revenue (14.3%) and earnings (16.3%) growth soar over the past three years, and has reported better-than-expected bottom line results in two consecutive quarters. In its latest Q4 FY2012 financials, which were reported last week, Cash America’s adjusted EPS of $1.29 beat Wall Street’s consensus by 11 cents per share. More importantly, loan demand—particularly for online loans—was a key factor behind this positive surprise.
From a valuation standpoint, shares of Cash America don’t look quite as attractive in comparison to key peer EZCORP Inc (NASDAQ:EZPW), but growth prospects sway slightly in favor of Cash America. EZCorp, which has operations in the United States and Mexico, generates about half of the revenue that Cash America does, and has historically experienced quicker EPS growth. Over the past half-decade, EZCorp has seen its bottom line expand by an average of 26.3% a year, far above Cash America’s 16.3% annual growth rate.
Over the next five years, however, analysts predict both companies’ yearly EPS growth to fall in the 15% range, meaning that EZCorp investors have to worry about a much larger falloff, logically speaking.
What else should investors pay attention to?
Both EZCorp and Cash America were active in the M&A space last year, with the former acquiring Crediamigo in Mexico, while Cash America bought 34 smaller pawn shops via two acquisitions in the U.S. Some analysts (see the full story here) are also concerned about EZ Corp’s dependence on inorganic growth, and the company has missed earnings in three of the past five quarters. Cash America, meanwhile, has only missed consensus once over this period, and is up more (9.9%) than EZCorp (-14.4%) over the past year.
It’s understandable that Kristynik has chosen Cash America over EZCorp—we’d rather have steady, consistent growth as well, and the company also pays a dividend (0.3% yield), while EZCorp does not.
Electronic Arts Inc. (NASDAQ:EA) is Kris Kristynik’s other small-cap holding, and is the smallest position in his 13F portfolio. Shares of the videogame developer have been in free-fall over the past 12 months, losing over 18% in the face of a few industry-specific headwinds. We’ve covered these issues before, but they boil down to: (1) a lack of next generation console hardware and (2) increased competition from mobile gaming. The latter issue is more secular in nature, and has negatively affected competitors Activision Blizzard, Inc. (NASDAQ:ATVI) and Take-Two Interactive Software, Inc. (NASDAQ:TTWO) as well.
Looking ahead, the sell-side expects EA to generate the best EPS growth of this trio, with early estimates predicting 13.8% annual expansion over the next half-decade. Analysts predict Activision and Take-Two to generate EPS growth of 9.3% and 13.2% over this time, and investors are rightfully valuing EA for this advantage. The stock trades at a little over 12 times forward earnings, above both Activision (11.6x) and Take-Two (5.6x), but it’s worth noting that EA is still at a 34% discount to the electronic gaming and multimedia industry’s average.
In terms of content, each game maker has its own franchises to ride, so to speak, over the next couple of years. Activision Blizzard launched the latest iteration of its World of Warcraft series last fall titled Mists of Pandaria, and like clockwork, we can expect that a new Call of Duty will be released this November. The company is also expected to publish a Halo-successor with an MMO slant codenamed Destiny at the end of this year, and WoW-successor Titan is expected in 2014.
Take-Two subsidiary 2K Games will release the much-anticipated BioShock Infinite this March, and it is set to release the Rockstar Games-developed Grand Theft Auto V sometime in the second quarter.
EA, meanwhile, offers investors a bit more stability with its pipeline, and is set to release popular shooters Crysis 3 and Dead Space 3 next month. More importantly, EA Sports gives the company an established collection of proven franchises updated yearly, including Tiger Woods PGA Tour, NCAA Football, Madden, FIFA and NHL. Almost all of EA’s sports-related franchises hold dominant positions in their respective genres, and should continue to do so with the introduction of next-gen consoles in the future.
In addition to the company’s growth-related advantage, another, more exciting prospect is EA’s potential in the digital content delivery realm. A key executive has already admitted that he sees EA becoming a “100% digital company,” which is a decidedly different opinion than Take-Two has articulated. Activision Blizzard is positioning itself more closely in EA’s corner, but when push comes to shove, it’s hard for investors to argue with Kristynik’s choice out of these three companies.
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Disclosure: I have no positions in any of the stocks mentioned above