Merchants’ Gate Capital’s Top Stock Picks

Merchants’ Gate Capital is a relative newcomer to the hedge fund community, opening in 2007 with about $650 million in assets under management. It must be doing well however: by 2011, it was ranked as one of the 100 largest U.S. equity focused hedge funds. Merchants’ Gate is managed by Jason Capello, who previously ran equity research at Ospraie Management. In August, the fund filed its 13F with the SEC in which it disclosed many of its positions as of the end of June. See a list of stocks Merchants Gate owned at the end of the second quarter or read on for our quick take on the five largest holdings it reported.

United Parcel Service, Inc. (NYSE:UPS)

Merchants’ Gate’s top stock pick was United Parcel Service, Inc. (NYSE:UPS), increasing its stake by 76% to a total of 1.9 million shares. Big Brown currently has a market capitalization of about $70 billion, which equates to 18 times the company’s trailing earnings. Investors are likely worried about competitor FedEx’s recent revision to guidance, taking it as a sign that shipping volumes are falling. UPS pays a dividend yield of 3.2% at current prices. It’s not quite a pure value or income stock, but offers a little bit of both. Edgar Wachenheim’s Greenhaven Associates was the top hedge fund holder of the stock according to our 13F database, reporting a position of 3.9 million shares.

The fund stuck with logistics for the #2 slot in its 13F portfolio, adding shares to its position in Expeditors International of Washington (NASDAQ:EXPD) and closing June with 6.2 million shares in its portfolio. The $7.8 billion market cap Expeditors International operates an air freight business and also distributes and consolidates shipments. It doesn’t look as good to us as UPS: its forward multiple of 19 is actually higher than that of the larger company, last quarter it saw declines in revenue and earnings compared to the same period in 2011, and its dividend yield is even lower. We would avoid it.

Schlumberger Limited. (NYSE:SLB) made our list of hedge funds’ top ten picks in the energy sector (find more energy stocks hedge funds are crazy about) and Capello and his team contributed to that positioning by owning 2.6 million shares at the end of the second quarter (more than triple what they had owned at the beginning of April). The oilfield services company is one way to play the boom in onshore oil and gas drilling in the U.S. Wall Street analyst consensus places Schlumberger as trading at a forward P/E of 14, and looking out over the next five years the five-year PEG ratio is 1. With an expected earnings growth rate equal to the stock’s current P/E, Schlumberger could be a good source of “growth at a reasonable price.”

Merchants’ Gate initiated a position of 4.5 million shares in J.C. Penney Company, Inc. (NYSE:JCP) during the second quarter, apparently finding some value potential in the struggling retailer. JC Penney is down 11% over the last year despite a rise in the broader markets (the S&P 500 is up 24% over the same time frame) and we’d note that this is justified as its sales last quarter came in 23% below what the company did in the same period a year ago. The sell-side is skeptical of a recovery, as their earnings estimates for the next fiscal year imply a forward P/E multiple of 19, and we are skeptical as well.

Ecolab Inc. (NYSE:ECL), a $19 billion market cap cleaner and cleaning equipment company, rounded out the top five slots in Merchants’ Gate’s 13F portfolio. At a beta of 0.6, Ecolab is less dependent on the broader economy than many of the fund’s other picks. It also showed substantial growth over the last year: in the second quarter of 2012, its revenues were up 74% and its earnings were up 47% versus the same quarter a year ago. However, the stock’s trailing price-to-earnings ratio of 37 suggests that quite a bit of future growth is already baked into the current price.