Our research shows that the most popular small cap stocks among hedge funds earn an average excess return of 18 percentage points per year (learn more about our small cap strategy). We think that this is the case because small cap stocks (which we define as those with market capitalizations between $1 billion and $5 billion) are less widely owned by large institutional investors such as mutual funds and less widely followed in the financial media, and so hedge fund teams are more likely to identify an undervalued (or overvalued) stock. We can also look at top small cap picks from individual fund managers, allowing investors to do further research on any stocks which seem like good values. Here are five small cap stocks which Christopher Lord’s Criterion Capital owned at the beginning of January (or see the full list of stocks the fund reported owning):
Criterion increased the size of its position in athenahealth, Inc (NASDAQ:ATHN) to a total of about 860,000 shares by the end of 2012. The healthcare billing and records software company reported double-digit growth rates in both revenue and earnings in the fourth quarter of 2012 versus a year earlier. However, the valuation is very aggressive- the stock trades at 60 times forward earnings estimates- and 34% of the float is held short as many market players think the price is too high. Robert Joseph Caruso’s Select Equity Group was the only other fund we track to have more than $20 million invested in athenahealth, Inc (NASDAQ:ATHN).
Lord and his team more than doubled their holdings of Palo Alto Networks Inc (NYSE:PANW) and closed2 2012 with 1.1 million shares in their portfolio. Palo Alto Networks Inc (NYSE:PANW) is a $3.7 billion market cap provider of networking and communications devices and software. It too is very expensive in terms of its bottom line: analyst consensus for the fiscal year ending in July 2014 implies a forward P/E of over 100, and even that figure is based on earnings per share doubling in that year compared to this one. The company has been delivering strong revenue growth, but we still think that we would avoid it for now.
Robert Half International Inc. (NYSE:RHI) was another of Criterion’s small cap picks; the investment team initiated a position of 1.6 million shares in the staffing company. Robert Half’s earnings rose 16% in the first quarter of 2013 versus a year earlier, but revenue was essentially flat. The stock carries trailing and forward earnings multiples of 21 and 15, respectively, so the market is expecting high earnings growth here as well. Billionaire Ken Griffin’s Citadel Investment Group was also buying Robert Half International Inc. (NYSE:RHI), and owned 2.8 million shares at the end of Q4 (check out Griffin’s stock picks).
The fund disclosed ownership of 1.5 million shares of Splunk Inc (NASDAQ:SPLK), a $4.2 billion market cap cloud software company. Splunk Inc (NASDAQ:SPLK) is slightly unprofitable on a trailing basis, though it did report low profits in its most recent quarterly report (a report which also recorded 51% revenue growth compared to the same period in the previous fiscal year). The sell-side is projecting 11 cents in EPS for the forward fiscal year, and so the forward P/E is very high here as well. SAC Capital Advisors, managed by billionaire Steve Cohen, initiated a small position per its own 13F (find Cohen’s favorite stocks).
Criterion owned 2.9 million shares of intellectual property software company Cadence Design Systems Inc (NASDAQ:CNDS), a 79% increase from what it had owned at the end of September. This company actually trades at only 14 times forward earnings estimates, and analysts expect earnings to grow over the next several years with the result being a five-year PEG ratio of 0.8. Sales rose 12% in its last quarterly report compared to the fourth quarter of 2011. Donald Chiboucis’s Columbus Circle Investors was another major shareholder in Cadence Design Systems Inc (NASDAQ:CNDS) (research more stocks Columbus Circle owns).
Disclosure: I own no shares of any stocks mentioned in this article.
