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Two Sigma Advisors’ Best Stock Picks: Taubman Centers, Inc. (TCO), Ares Capital Corporation (ARCC)

Small-cap stocks don’t get as much attention from analysts, which often leaves them less efficiently priced than their larger peers. As can be expected, hedge funds sometimes take advantage of this by dedicating their research teams to work on the small-cap space.

In fact, retail investors can use hedge funds’ top small-caps as a market-beating strategy; we’ve determined that the most popular small-cap stocks among hedge funds can earn about 120 basis points of alpha per month. We started publishing a quarterly newsletter at the end of August and since then, until the end of December, this strategy returned 14.3% vs. 2.1% for the S&P 500 index (learn more about our hedge fund small cap strategy).

Keeping this in mind, we’re going to take a look at one fund in particular: John Overdeck and David Siegel’s Two Sigma Advisors. Overdeck and Siegel have a fairly large equity portfolio (see the fund’s entire stock picks here), but let’s focus on Two Sigma’s top five small-cap holdings. As is consistent with our strategy, each stock has a market capitalization between $1 billion and $5 billion.

Taubman Centers, Inc. (NYSE:TCO)

Two Sigma’s No. 1 small-cap stock pick is Taubman Centers, Inc. (NYSE:TCO). Taubman is a retail-focused REIT, generating a 2.3% dividend yield and impressive appreciation near 30% over the past twelve months. One of Taubman’s key advantages is its ability to grow through acquisitions, and according to Morningstar, the REIT leads its peers with a tenant sales per square foot north of $680. Taubman trades at depressed sales (6.7x) and cash flow (15.2x) multiples—both around 15% lower than industry averages—so there’s clearly some value here as well.

Next up we have Ares Capital Corporation (NASDAQ:ARCC), the 17th largest holding in Two Sigma’s 13F portfolio and the fund’s second favorite small-cap. Ares Capital is a business development corporation, or BDC, that invests in a wide range of companies. Most of Ares Capital’s investments are located in the Western U.S., with more than 40% of its assets invested in 1st lien senior debt. Now, as far as BDC’s go, this percentage isn’t top-tier, but it is still solid nonetheless. Ares Capital has seen relatively stagnant earnings over the past half-decade, but the sell-side expects EPS to grow by an average of 6.8% a year through 2017. At less than 11 times forward earnings and a PEG of 1.25, this is another value play.

Who’s the best of the rest?

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