Here’s Why You Should Check Out Nantahala Capital Management’s Picks

There are thousands of hedge funds out there, but only a few manage to not only beat the market, but post substantial returns. With the Dow and S&P 500 at historical highs, many investors choose to invest in index funds instead of hedge funds. And it makes sense, since index funds have been outperforming many hedge funds and they don’t charge an arm and a leg. For example, Bill Ackman‘s Pershing Square lost 13.5% in 2016 and 20.5% in 2015, while David Einhorn‘s Greenlight Capital returned around 13%, beating the S&P 500 only by one percentage point. It should be noted though that these funds still have great historical returns.

As investors have started to become disappointed in hedge funds and have looked for other ways to invest their money, many funds have closed. In fact, 2016 registered the largest number of hedge fund closures since the financial crisis, with 1,057 closing their doors. At the same time, only 729 funds were started, the smallest number in almost a decade. Nevertheless, the 9,893 funds in operation managed over $3.02 trillion in assets last year, with 70% being controlled by funds with over $5 billion in assets.

For smaller investors, hedge funds can be a great source of information. Despite their lagging returns in the last several years, hedge funds still employ a lot of resources to identify profitable investing opportunities and have more skills than smaller investors. Many hedge funds file quarterly 13F filings in which they disclose their equity positions, and even though they are filed 45 days after the end of a quarter, due to hedge funds’ medium- to long-term investment horizon, we can still benefit from this information.

Following one or several hedge funds and imitating some of their picks can be an effective market-beating strategy, but not as effective as following several hundred funds. That’s what we do at Insider Monkey. Our database has over 700 hedge funds whose 13F filings we analyze to identify investment opportunities, which we share with our premium subscribers. Our flagship strategy has posted a gain of over 44% since February 2016, beating the S&P 500 ETF (SPY) by around 20 percentage points. The stock picks that we shared in February were 5 percentage points ahead of the market over the following three months, and our latest newsletter has just been released to our subscribers, so it’s not too late to take advantage by accessing this link.

One fund that is flying under the radar of big media outlets is Nantahala Capital Management, managed by Wilmot B. Harkey and Daniel Mack. Nantahala was launched by Harkey in 2004 and invests in companies with equity or debt priced incorrectly by the market due to factors that can be identified and are expected to be corrected in the near future. The fund is relatively unknown to the wider public, probably because of its small size, but its performance is not something to be overlooked. According to our calculations, Nantahala’s stock picks in companies with a market capitalization of over $1.0 billion returned 29% in the first quarter.

In its latest 13F filing, Nantahala reported an equity portfolio worth $897.74 million as of the end of March, down from $963.29 million a quarter earlier. The portfolio is diversified across sectors, with Finance and Technology stocks amassing the largest shares, at 29% and 21%, respectively. During the first quarter, the fund added nine positions and liquidated 17 holdings.

On the next page, we are going to take a look at three of its largest positions, Dolby Laboratories, Inc. (NYSE:DLB), Yahoo! Inc. (NASDAQ:YHOO), and FirstCash Inc (NYSE:FCFS).

In Dolby Laboratories, Inc. (NYSE:DLB), Nantahala held 902,500 shares worth $47.30 million at the end of March. The company’s stock has gained 13% since the beginning of the year and is up by over 67% since the fund initiated a stake in the company during the fourth quarter of 2011. In 2011, Dolby’s stock slid by over 54% as investors became concerned about a slowdown in PC sales. However, the subsequent recovery of the stock shows that those concerns were premature.

Dolby managed to unlock new revenue streams in the mobile segment, thanks to Apple Inc. (NASDAQ:AAPL) devices beginning to support Dolby Audio, and the company is working to integrate the technology with Android devices. As the company earns a small fee from each device sold through the licensing of its technology, the growth potential should be strong. Another catalyst that could boost the company’s stock value is its imaging technology, Dolby Vision, which will become more popular once Ultra HD 4K TVs start to gain traction. Overall, there were 22 funds from our database holding shares of Dolby Laboratories, Inc. (NYSE:DLB) at the end of March, down from 33 funds a quarter earlier. Aside from Nantahala, another shareholder of the company is Brian Ashford-Russell and Tim Woolley’s Polar Capital, which reported ownership of 1.69 million shares in its latest 13F filing.

Yahoo! Inc. (NASDAQ:YHOO) represented Nantahala’s second-largest position at the end of the first quarter. The fund disclosed a $44.11 million position that contained 950,425 shares in its latest 13F filing, up by 7% over the quarter. Yahoo! Inc. (NASDAQ:YHOO)’s stock is 31% in the green so far this year. As Yahoo! Inc. (NASDAQ:YHOO) expects to close the sale of its core assets to Verizon Communications Inc. (NYSE:VZ) for $4.40 billion in mid-June, some analysts believe that the stock is still undervalued.

The company is expected to monetize on its key assets, such as its $47 billion stake in Alibaba Group Holding Ltd (NYSE:BABA), which values its assets at around $71 per share, according to Brett Harriss of Gabelli & Co, as quoted to Barron’s. UBS has also recently raised its price target on Yahoo! Inc. (NASDAQ:YHOO) to $58 from $50, citing the tax efficiency that the company will focus on while dealing with its 15% stake in Alibaba and 35% stake in Yahoo Japan. Among the funds tracked by us, the number of investors bullish on Yahoo! Inc. (NASDAQ:YHOO) inched down by one to 82 during the first three months of 2017. Jeff Smith’s Starboard Value held 12.30 million shares of the company at the end of March.

Last but not least, in FirstCash Inc (NYSE:FCFS) Nantahala held 883,772 shares worth $43.44 million heading into the second quarter. The fund was one of the 12 investors in our database that had collectively amassed 6.90% of the company’s outstanding stock at the end of March. Aside from Nantahala, another shareholder of FirstCash Inc (NYSE:FCFS) is Amy Minella’s Cardinal Capital, which disclosed holding 969,942 shares in its most recent 13F filing.

Shares of the operator of retail-based pawn shops have advanced by 14.4% since the beginning of 2017. Last year, First Cash Financial Services, Inc. and Cash America completed their merger of equals, creating a larger and more geographically diversified company. With First Cash bringing to the table its operations in Latin America, mainly in Mexico, the company has also become more exposed to other currencies, notably the Mexican peso. Nevertheless, the company’s latest financial results were better than expected. FirstCash Inc (NYSE:FCS) posted EPS of $0.77 for the fourth quarter, beating estimates by $0.01, while revenue of $462.04 million surged by 141.4% on the year (due to the merger) and topped estimates by $10.4 million.

Disclosure: None