So, if David Einhorn can’t beat the market by investing in large-cap stocks, why is he so famous and how did he generate average annual net returns of 18.9%?
The secret is his small-cap stock picks. He has been investing in small-cap stocks for a very long time. Our dataset covers the 1999-2012 period. Einhorn’s small-cap stock picks returned an average of 121 basis points per month during these 14 years. S&P 500 Index returned only 32 basis points per month during the same period. This means Einhorn was able to beat the market by more than 10 percentage points per year by investing in small-cap picks. You may say “hey, small-cap stocks are riskier and anyone could have done the same by simply investing in small-cap index funds”. That’s why we use Carhart’s 4-factor model to adjust our results by taking into account known factors that affect returns. Einhorn’s 4-factor alpha for his small-cap picks was 55 basis points per month. This is more than 6.5 percentage points annualized.
These results reveal a huge secret about David Einhorn and Greenlight Capital. Einhorn has a significant edge in picking small-cap stocks and has been a rather pedestrian large-cap-stock investor recently.
We developed an investment strategy that invests in some of the most popular small-cap stocks among hedge funds. Between 1999 and 2009 this strategy outperformed the market by an average of 18 percentage points per year. We have been sharing the stock picks of this strategy in real-time since the end of August 2012. The strategy’s picks had a cumulative return of 132% since then. S&P 500 index funds returned less than 55% during the same period. If investors want to piggyback hedge funds like Greenlight Capital, they should focus on their small-cap stock picks.
At the end of 2014 Einhorn’s top three small-cap picks were Aecom (NYSE:ACM), On Semiconductor Corp (NASDAQ:ONNN), and Take Two Interactive Software Inc. (NASDAQ:TTWO). Among these three stocks Take Two Interactive Software Inc. was the most popular among hedge funds. At the end of December there were a total of 34 hedge funds with bullish positions in the stock. Joel Greenblatt and Spencer Waxman had large positions in the stock.
On Semiconductor Corp is next in line with a total of 28 hedge funds. Billionaire Steve Cohen, Josh Resnick, and Dmitry Balyasny initiated brand new positions in the stock during the fourth quarter. Finally, Aecom (ACM) was in 24 hedge funds’ portfolio. Joel Greenblatt’s magic formula was pointing again another Einhorn pick. He increased his ACM bet by 375% during the fourth quarter. Curtis Macnguyen and Thomas Bailard also initiated brand new positions in the stock during the fourth quarter.
We will take a detailed look at these three stocks in the second part of this article. We like these stocks because our David Einhorn indicator has generated strong returns in the past. We believe investors would benefit more if they switch their attention from Apple Inc. (AAPL) to these three small and underfollowed stocks.