Large institutional investors such as mutual funds tend to be less focused on small cap stocks (which we define as those with market capitalizations between $1 billion and $5 billion), and it’s often suggested that this makes these stocks more likely to be mispriced. Hedge funds who look at these stocks are therefore more likely to find undervalued or overvalued names to trade accordingly. Our research has shown that the most popular small cap stocks among hedge funds, as determined by an analysis of 13F filings, generate an average excess return of 18 percentage points per year; we’ve been live testing this strategy since September 2012, when it has returned 38%. We can also look at small cap picks from individual hedge funds and treat these as initial investment ideas. Read on for our thoughts on billionaire John Paulson’s Paulson & Co.’s five largest small cap holdings by market value as of the end of March (with the exception of the acquired MetroPCS) or review Paulson’s previous filings.
The fund reported a position of 5.9 million shares in AMC Networks Inc (NASDAQ:AMCX), the $4.8 billion market cap owner of cable TV channels including AMC, WE tv, and IFC. AMC has been delivering rapid growth recently: in the first quarter of 2013, revenue rose by 17% versus a year earlier with net income growing by over 40% over the same time frame. However, the market is already pricing in high earnings growth going forward as the stock trades at 31 times trailing earnings. It might be best to wait for more results from the company.
Paulson specialized in merger arbitrage prior to his legendary short of subprime mortgages prior to the financial crisis, but following poor results in macro investments (particularly gold) since then he has become more focused on merger arb again. Another of his large small cap holdings, Mcmoran Exploration Co (NYSE:MMR) is an oil and gas exploration and production company set to be acquired by Freeport-McMoRan Copper & Gold. Freeport-McMoRan is offering $14.75 in cash to McMoRan shareholders in addition to participation in a royalty trust; the stock’s current price is $16.84, implying a significant value for the trust participation.
Telecommunications and media company Cablevision Systems Corporation (NYSE:CVC) was another of Paulson’s small cap picks with the filing disclosing ownership of almost 17 million shares. The company, whose assets include Clearview Cinemas and Newsday, also looks pricy in terms of its earnings multiples: its forward P/E, for example, is over 30. Cablevision has been making significant dividend payments for the past several years, and its current yield is about 4%. Income investors might want to consider it on that basis but should also be sure that the stock is not too expensive.
Paulson and his team increased their stake in Popular Inc (NASDAQ:BPOP), a bank operating in Puerto Rico and in select markets in the United States. Even after a 90% increase in the stock price over the last year, Popular trades at a considerable discount to the book value of its equity with a P/B ratio of 0.8. While the business has been struggling recently, Popular is also a value in terms of consensus earnings forecasts for 2014 with analyst projections implying a forward earnings multiple of 9. We think that the bank could be considered alongside other cheap regional banks.
Rounding out our list of Paulson’s small cap picks is troubled casino Caesars Entertainment Corp (NASDAQ:CZR). The company is not expected to be profitable either this year or next year, with losses per share forecasts being quite high. 29% of the float is held short as many market players worry about the struggling business and its very high leverage. Even for the casino industry- where the profitable players carry high earnings multiples- we think that the market looks too optimistic on Caesars if anything. Billionaire George Soros owned 5.7 million shares of the stock at the end of March (check out Soros’s stock picks).
Disclosure: I own no shares of any stocks mentioned in this article.