By Jake Mann
Hedge funds find a significant fraction of their alpha in the small-cap world. Broadly speaking, there is less publicly available information about these stocks, so this makes logical sense. We've empirically tested this, and according to our own analysis, investing in the hedge fund industry's top small-cap picks has generated an alpha of about 120 basis points per month. We started publishing a quarterly newsletter at the end of August and shared the stock picks of this strategy. Since then this strategy returned 14.3% (between September and December) vs. 2.1% for the S&P 500 index (learn more about our small-cap strategy).
While it's tempting to simply take the word of these notable investors, it's also important to delve into the details of these lesser-known companies, so we can better understand why they are drawing interest from the smart money.
Although Ken Fisher's Fisher Asset Management isn't technically a hedge fund, the general characteristics of its equity portfolio are still similar to its hedgie peers. As noted in Fisher's latest 13F filing with the SEC, there are a few small-cap stocks that are worth taking a look at.
Without further ado, we give you his top five "under-the-radar" stock picks; each had a market capitalization between $1 billion and $5 billion at the end of the third quarter. This criterion is the same as we use in our small-cap strategy, which is mentioned above.
Cabela's (CAB) was Fisher's No. 1 small-cap stock pick. Shares of the outdoor-focused retailer have gained 13.6% in the past six months, and are still trading at a relatively attractive valuation, at a forward P/E near 14x. After meeting or beating Wall Street's earnings estimates in the first three quarters of its 2012 fiscal year, analysts are expecting the company to close out the period with a Q4 EPS of $1.21. If Cabela's is able to meet this target when it reports next month, it will have grown its bottom line by 26.4% year over year.
From a macro standpoint, an obvious growth driver for Cabela's has been gun sales, which are estimated to have hit a record-high in December. According to the FBI, which tracks statistics related to background check requests on gun customers, over 2.7 million such requests occurred last month. Whether this boom has any effect on Cabela's remains to be seen, but an outperformance in next quarter's earnings is certainly in the cards.
NCR Corporation (NCR), the designer of self and assisted-service kiosks, is Fisher's second largest small-cap investment. Best known for its ATM business, NCR has quite a bit of bulls on the Street. The sell-side expects the company's earnings expansion to accelerate rapidly over the next half-decade, averaging growth close to 14% a year compared to the general declines it has experienced since 2007.
In addition to bullish demand from players in the banking industry, NCR's kiosks also have solid potential in other areas, including restaurants, travel and gaming. More excitingly, a mobile shopping program that allows store customers to scan their items while they browse is potentially revolutionary. NCR's mobile point-of-sale system has just started its rollout, and is still looking for support from the industry's larger retail players.
SVB Financial Group (SIVB) is the No. 3 small-cap stock in Fisher Asset Management's 13F portfolio. The company operates a financial services segment in addition to serving as a holding company for Silicon Valley Bank. One of SVB's main specialties is its focus on providing support for companies early in their development cycle, from private equity to technology.
According to the bank itself, it has had a hand in close to 50% of all venture capital-backed tech and life science companies in the U.S. This market dominance, along with a rosy earnings forecast-the sell-side's consensus is that growth will average 13.0% a year through 2017-gives investors plenty of reasons to be bullish. Shares of SIVB currently trade at a modest earnings growth multiple (PEG) of 1.29, below most of its comparables like Comerica (CMA) (1.79) and Bank of America (BAC) (4.09).
Domino's Pizza (DPZ) is Fisher's fourth largest small-cap investment. While market share estimates vary, it's widely believed that Domino's holds 15-25% of the domestic pizza delivery market share, below Pizza Hut but above Papa John's (PZZA) and Little Caesars. Now, Domino's isn't a take 'n' bake master like Papa Murphy's, for example, but it does provide customers with relatively balanced menu options at a low cost.
A key advantage for Domino's is its presence in emerging markets. The company estimates that store growth in this space has totaled 30% since 2008 (through August 2012), trumping the likes of Dunkin (DNKN), Starbucks (SBUX), Yum (YUM) and McDonald's (MCD).
Interestingly, the average analyst price target on Domino's currently rests at $45.17, nearly at parity with January 11th closing price of $45.16. At an earnings growth multiple near 2.0, it may be best to wait until a more attractive entry point appears to consider buying into the stock.
Last but not least, Sally Beauty Holdings (SBH) is the fifth largest small-cap holding in Fisher's 13F portfolio. The fund manager's fifth largest small-cap investment has been rewarding over the past year, returning a little over 18%. Sally Beauty is a specialty beauty supply retailer, offering its own goods as well as third-party products from major industry players like L'Oreal (LRLCY.PK) and Conair (CNGA.PK).
This diversification is appealing, but it's the stock's relatively attractive valuation (PEG of 1.29) and decent expected five-year EPS growth (15-16% annually) that may have caught Fisher's eye. The stock is far cheaper than similarly sized peer Ulta Salon (ULTA), which trades at a PEG of 1.49.