We track quarterly 13F filings from hundreds of hedge funds as part of our work researching investment strategies, and have found that the most popular small cap stocks among hedge funds outperform the S&P 500 by an average of 18 percentage points per year. We think that this is because small cap stocks (which we define as those with market capitalizations between $1 billion and $5 billion) receive less attention from large institutional investors and the financial media, and so are more likely to be mispriced. Investors can also review the small cap picks of top investors such as billionaire Glenn Dubin’s Highbridge Capital Management and do further research on any interesting names, similarly to how stock screens are often used. Here are the five largest positions in small cap stocks from Highbridge’s portfolio as of the end of March (or see the full list of the fund’s stock picks):
Dubin’s largest holding overall by market value was his nearly 27 million shares of Cosan Limited (USA) (NYSE:CZZ). Cosan is a $4.3 billion market cap Brazilian company which primarily produces sugar and ethanol from sugar cane. Markets are pricing in high growth at the company- the trailing P/E is 24- but Wall Street analysts still believe that the business is underestimated as their forecasts imply a forward earnings multiple of only 9 and a five-year PEG ratio well below 1. The stock is now down almost 10% year to date after plunging in late May and June.
Another growth stock which Highbridge liked was Ctrip.com International, Ltd. (ADR) (NASDAQ:CTRP), a Chinese travel services company which arranges hotels, airlines, and tours. The stock price has nearly doubled in the last year, and with earnings actually down over 20% in the first quarter of 2013 versus a year earlier the trailing earnings multiple has risen to 44. Revenue has been up, and the sell-side is looking for some improvement in 2014 in terms of net income, but still the stock trades at over 30 times forward earnings estimates and we would avoid it.
The fund cut its stake in United Rentals, Inc. (NYSE:URI) by 37% between January and March but still reported a position of 1.6 million shares. The $4.8 billion market cap company rents industrial and construction equipment, a business which leaves the stock highly correlated to the broader economy at a beta of 3.0. United Rentals, Inc. (NYSE:URI), like Cosan Limited (USA) (NYSE:CZZ), is expensive in terms of trailing earnings but has high upside potential (with a five-year PEG ratio of 0.5). Citadel Investment Group, managed by billionaire Ken Griffin, reported a position of 1.4 million shares in its own 13F (find Griffin’s favorite stocks).
Wealth management company SEI Investments Company (NASDAQ:SEIC) was another of Dubin’s small cap picks as the filing disclosed ownership of 2.7 million shares. In its last quarterly report, revenue was up by 14% compared to the first quarter of 2012 and this helped drive more than a 40% increase in earnings. The stock carries trailing and forward P/E multiples of 22 and 16, respectively, so markets have already accounted for some future growth, but it might be worth looking into SEI Investments Company (NASDAQ:SEIC) to see if it can continue to see double-digit growth for the next few years.
Highbridge owned 1.8 million shares of Echostar Corporation (NASDAQ:SATS), a $3.4 billion market cap provider of digital set-top boxes, as of the beginning of April. Adjusted earnings numbers at the company appear to be in decline, and the stock trades at over 100 times forward earnings estimates as the sell-side is not particularly optimistic on EchoStar; there is a wide range of forecasts but even the high estimate calls for less than $1 per share for a company whose current stock price is over $30. Revenue numbers have been up only slightly.
We would therefore stay away from Echostar Corporation (NASDAQ:SATS) as well as Ctrip.com International, Ltd. (ADR) (NASDAQ:CTRP). The other three companies we’ve covered here are highly dependent on future growth. While certainly not value plays at these levels, United Rentals, Inc. (NYSE:URI) and SEI have been delivering impressive results recently and so they could be worth checking out to see how sustainable that performance is. Cosan Limited (USA) (NYSE:CZZ) is a possibility as well for investors who are bullish on Brazil and/or sugar cane ethanol.
Disclosure: I own no shares of any stocks mentioned in this article.
