Hedge Funds Were Right to Ditch These Sinking Stocks, Part 1

Although hedge funds don’t always get it right, they outperform the market when factoring in known risk factors because of the in-depth research and the world-class, financially-savvy workforce that they employ. With many Ivy League graduates and extensive industry connections at their disposal, hedge funds often see sector downturns before everyone else. In this article we examine five stocks that the hedge funds tracked by Insider Monkey became less bullish on in the third quarter, ahead of them sinking (or continuing to sink) in the fourth quarter. Those stocks are Devon Energy Corp (NYSE:DVN), Whiting Petroleum Corp (NYSE:WLL), Magna International Inc. (USA) (NYSE:MGA), Dynegy Inc. (NYSE:DYN), and Canadian Pacific Railway Limited (USA) (NYSE:CP). In Part 2 of this two-part feature, we’ll cover five more stocks that smart money was wisely getting rid of during the third quarter.

Most investors don’t understand hedge funds and indicators that are based on hedge funds’ activities. They ignore hedge funds because of their recent poor performance in the bull market. Our research indicates that hedge funds underperformed because they aren’t 100% long. Hedge fund fees are also very large compared to the returns generated and they reduce the net returns experienced by investors. We uncovered that hedge funds’ long positions actually outperformed the market. For instance the 15 most popular small-cap stocks among funds beat the S&P 500 Index by 53 percentage points since the end of August 2012. These stocks returned a cumulative of 102% vs. a 48.7% gain for the S&P 500 Index (see the details here). That’s why we believe investors should pay attention to what hedge funds are buying (rather than what their net returns are).

#5 Canadian Pacific Railway Limited (USA) (NYSE:CP)

 – Number of Hedge Fund Holders (as of September 30): 39
– Total Value of Hedge Fund Holdings (as of September 30): $3.98 billion
– Hedge Fund Holdings as Percent of Float (as of September 30): 17.80%

The number of elite funds long Canadian Pacific Railway Limited (USA) (NYSE:CP) dropped by 12 to 39 during the third quarter, with many funds likely selling before the stock made a major down move in August. Shares are down by another 14% in the fourth quarter. With oil and gas prices so low, demand for oil and coal train shipments isn’t what it used to be and investors are no longer as optimistic about the stock. Canadian Pacific shares could have some additional short-term downside if the company ramps up its bid to acquire Norfolk Southern Corp. (NYSE:NSC). Canadian Pacific originally bid $28.4 billion for the company, but its offer was rejected. Bill Ackman‘s Pershing Square owned 13.94 million CP shares at the end of September.

#4 Dynegy Inc. (NYSE:DYN)

 – Number of Hedge Fund Holders (as of September 30): 40
– Total Value of Hedge Fund Holdings (as of September 30): $1.18 billion
– Hedge Fund Holdings as Percent of Float (as of September 30): 44.30%

With Dynegy Inc. (NYSE:DYN) shares retreating by 29.3% from June 30 to September 30, it isn’t surprising that the total number of elite funds long the stock fell to 40 from 52 during the same time frame. Because of weaker industry conditions and warmer weather, Dynegy’s outlook isn’t as bright as it once was. Management expects 2015 adjusted EBITDA to be $825 million-to-$925 million, down from the previous guidance of $825 million-to-$1.025 billion. Management also expects 2016 adjusted EBITDA to be $1.1 billion-to-$1.3 billion and 2016 free cash flow to be $300 million-to-$500 million, both of which are below expectations. Israel Englander‘s Millennium Management cut its Dynegy stake by 37.3% to 2.76 million shares. Those shares have lost another 47% of their value in the fourth quarter.

#3 Whiting Petroleum Corp (NYSE:WLL)

 – Number of Hedge Fund Holders (as of September 30): 42
– Total Value of Hedge Fund Holdings (as of September 30): $767.2 million
– Hedge Fund Holdings as Percent of Float (as of September 30): 24.60%

Many hedge funds got out of the way of a falling knife in Whiting Petroleum Corp (NYSE:WLL) in the third quarter, as the total number of elite funds long the stock fell to 42 by the end of September from 53 at the end of June. Whiting Petroleum Corp shares fell by over 50% in the same time frame and have fallen by another 26% in the fourth quarter as the price of WTI tanked on over-supply concerns. With Saudi Arabia pursuing its strategy of forcing out the weaker hands in a long-term bid to capture more market share, it’s not clear when WTI prices will recover. The U.S oil and gas industry could get some good news, however, if Washington lifts the crude export ban. According to multiple sources, negotiations to allow for just that are currently in progress.

#2 Magna International Inc. (USA) (NYSE:MGA)

 – Number of Hedge Fund Holders (as of September 30): 43
– Total Value of Hedge Fund Holdings (as of September 30): $1.33 billion
– Hedge Fund Holdings as Percent of Float (as of September 30): 6.80%

A net of nine elite funds were astute in their move to sell off Magna International Inc. (USA) (NYSE:MGA) in the third quarter, as shares of the company have fallen by over 13% in the fourth quarter. Magna International reported disappointing third quarter results as a strong dollar and weak global macro-economic environment weighed on performance. Sales missed estimates by $50 million and gross margin fell by 30 basis points. Guidance was also a bit soft, with the company expecting total sales of $31.3 billion-to-$32.6 billion and an operating margin of 7.7%. Nevertheless, 43 elite funds still own the stock, with Cliff Asness‘ AQR Capital Management among them.

#1 Devon Energy Corp (NYSE:DVN)

 – Number of Hedge Fund Holders (as of September 30): 48
– Total Value of Hedge Fund Holdings (as of September 30): $1.79 billion
– Hedge Fund Holdings as Percent of Float (as of September 30): 11.80%

A net of eight elite funds sold out of their positions in Devon Energy Corp (NYSE:DVN) during the third quarter, which may come as little surprise given that Devon shares fell by 37.3% from June 30-to-September 30. They have also fallen by another 9% in the third quarter. With the low WTI and natural gas prices, meaningful profits will be difficult to come by for the foreseeable future. While oil prices can’t stay low forever as non-OPEC production declines and crude demand grows by 1.0-to-1.5 million bpd per year, it’s difficult to be bullish at the current time given the impending Iranian crude coming onto the market and the weakening yuan. Legg Mason Capital Management, now a part of ClearBridge, was long 1.68 million shares of Devon Energy at the end of the third quarter.

Disclosure: None