Small-cap and mid-cap stocks are the source of much of a hedge fund’s alpha, as these stocks are less covered by the media and other large investors and therefore are more likely to be inefficiently priced. As a result a hedge fund’s research team is more likely to uncover value when evaluating companies with market caps under $5 billion, and so it’s not surprising that on average stocks in this valuation range that hedge funds buy tend to perform particularly well. We’ve estimated that the most popular small cap picks among hedge funds have an alpha of about 120 basis points per month (read more about our hedge fund small cap strategy).
Our small-cap investing strategy, with picks revealed in our August newsletter, returned 14% between September and December- we don’t expect to do quite that well in the future, but it does demonstrate that these stocks can be good values. Here are five stocks with market capitalizations between $1 billion and $5 billion that billionaire James Dinan’s York Capital Management reported owning in its most recent 13F filing (see the full list of Dinan’s stock picks):
Another stock on the fund’s top ten list was The Manitowoc Company, Inc. (NYSE:MTW). As primarily a provider of cranes and related equipment, Manitowoc is tied closely to construction activity and the stock has a very high beta of 3.7. As a result investors should be at least somewhat optimistic on the U.S. economy before considering buying. The trailing P/E is 26, but sell-side analysts think that this year will be much better and so the multiple based on 2013 consensus earnings is only 12. Malcolm Fairbairn’s Ascend Capital was also buying the stock.
Three more picks from York:
MetroPCS Communications Inc (NYSE:PCS) was another of Dinan and his team’s stock picks. MetroPCS’s P/E multiple based on expected earnings for 2013 is 13, with the sell-side projecting enough earnings growth over the next several years to generate a five-year PEG ratio of 0.7. John Paulson was also buying the stock in the third quarter of 2012, as Paulson & Co. reported a position of almost 24 million shares in its own 13F (check out Paulson’s stock picks).
York increased its holdings of Corrections Corp Of America (NYSE:CXW) by 13% to 1.9 million shares. The company is a private owner and operator of correctional and detention institutions in the United States. Its earnings multiples are fairly high, in the 23-25 range, as the markets anticipate high earnings growth over the next several years. Marcato Capital Management had Corrections Corp of America as its largest holding at the end of September (research more stocks Richard McGuire and the Marcato team like).
Dinan and the rest of the investment team sold shares of United Rentals, Inc. (NYSE:URI) but the construction and industrial equipment company was still one of its top five small-cap stocks. Sales and net income have been up, and the sell-side is optimistic here as well with the $4.4 billion market cap coming in at 10 times expected 2013 earnings. Like Manitowoc, United Rentals has a high beta (3.1 in this case, unsurprising given that its business is dependent on the demand for equipment). Short interest is high with 16% of outstanding shares held short. Point State Capital initiated a position of 3 million shares during Q3 2012 (see more stock picks from Point State Capital).
Disclosure: I own no shares of any stocks mentioned in this article.
