Small-cap stocks don’t get as much attention from most players in the financial world, which often renders them less efficiently priced than larger stocks. As can probably be expected, hedge funds take advantage of this differential, and hence, generate a significant portion of their alpha from the small-caps.
At Insider Monkey, we started publishing a quarterly newsletter at the end of August that follows hedge funds’ top small-cap picks. Since that point, until the end of last month, this strategy returned a 14.3% versus 2.1% for the S&P 500 index (learn more about our small-cap strategy). We’ve also backtested this analysis, and have found that hedge funds’ top small-cap picks have generated an alpha of about 120 basis points per month.
Let’s take a deeper look at one particular fund’s top three small-cap picks: Jamie Zimmerman’s Litespeed Management. Zimmerman’s equity portfolio is rather small, comprising just 13 different positions in total. It is worth mentioning, though, that she was able to generate a 17% return on these investments in the third quarter—the end of the firm’s last filing period with the SEC.
With that in mind, it should also be said that our database of 13F filings makes it possible to generate these findings; see Jamie Zimmerman’s full portfolio here for yourself. Each small-cap stock listed has a market capitalization between $1 billion and $5 billion, as is consistent with our strategy.
Zimmerman’s top small-cap stock pick is Macquarie Infrastructure Company (NYSE:MIC), sitting at No. 3 overall in the money manager’s portfolio. Macquarie is a heavily diversified infrastructure company, with operations in auto parking, airport refueling, and gas delivery. The most attractive aspect of MIC from an investment standpoint is its dividend, which is projected to yield 5.7%. Over the past year, this payout has been boosted by the stock’s appreciation, which has returned a cool 65.6%.
Going forward, it looks as though investors are most bullish about Macquarie’s gas business, and the sell-side expects earnings growth to average 11% a year over the next half-decade. Macquarie’s bottom line has actually shrunk by nearly 20% annually—on average—over the past five years, so this forecast is a welcome turnaround.
Shares of the company currently trade at a mere 11.8 times next year’s earnings, but the stock’s PEG of 5.7 indicates that the markets may be overvaluing its long-term prospects. Ardent investors would be wise to find a more attractive entry point, but it’s worth noting that Wall Street’s average price target is near $51.75, a good 7-8% upside from current levels.
Who’s the best of the rest?
Next up we have Theravance Inc (NASDAQ:THRX), the biopharmaceutical company that is already up over 10% year to date. Much of the optimism surrounding Theravance at the moment is related to its partnership with GlaxoSmithKline plc (NYSE:GSK). The duo recently announced that they are seeking approval of a drug used to alleviate symptoms of chronic obstructive pulmonary disease, called Anoro. The two companies are also partnering to develop several other related programs, and in general, investors have much to be excited about concerning their efforts in the respiratory arena.
From a valuation standpoint, both stocks’ paths are mixed. Theravance trades at 8.4 times its cash, while GSK sports a P/C multiple of 18.4x. THRX’s sales multiple is near 17x, though, while GlaxoSmithKline is almost one-fourteenth as expensive. Book multiples also side with GSK, and its 5.3% dividend certainly adds to its allure. Still, Theravance has been a much hotter stock in recent months, and has the most to gain from an approval of Anoro and the rest of its drugs in development.
Zimmerman’s third—and final—small-cap stock at the end of the last filing period was Ralcorp Holdings, Inc. (NYSE:RAH). The food processing company was bought out by ConAgra Foods, Inc. (NYSE:CAG) late last year, for close to $7 billion after debt. Generally speaking, the most attractive aspect of Ralcorp’s business was its private-label portfolio, which has done well in a muted economic recovery.
After the deal, Ralcorp and ConAgra’s private-label business will now be the largest in North America, with annual sales in excess of $4 billion from this segment alone. ConAgra’s total sales are estimated to fall between $17 billion and $20 billion annually, and the stock currently trades at a trailing P/S below 1.0.
The sell-side expects the company’s bottom line to sport growth of 8-9% a year over the next half-decade, more than double the expansion it has seen since 2008. With a projected dividend yield above 3.0%, ConAgra is the rare stock that pleases both income and growth-oriented investors.
To see more details about how to beat the market using Insider Monkey’s small-cap strategy, check it out here.
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Disclosure: I have no positions in any of the stocks mentioned in this article