By Jake Mann
Hedge funds obtain a substantial portion of their alpha from stocks in the small-cap space. Due to the fact that public research about these companies tends to be less efficient than their larger peers, this makes sense. According to our own analysis, investing in the most popular small-cap picks among hedge funds has generated an alpha of about 120 basis points per month (read more about our small-cap strategy).
At Insider Monkey, we started publishing a quarterly newsletter at the end of August, and since then (through December) this strategy returned 14.3% vs. 2.1% for the S&P 500 index (here's full access to our newsletter).
With that being said, we're going to take a look at the top five small-cap picks from Dmitry Balyasny's Balyasny Asset Management. Each stock has a market capitalization between $1 billion and $5 billion; this is the same criterion used in our strategy.
First up on our list is Chicago Bridge & Iron Company (NYSE:CBI). As can be seen in Balyasny's latest 13F filing with the SEC (see the hedge fund's full portfolio here), Chicago Bridge & Iron is the money manager's largest equity position in general. Chicago Bridge & Iron acquired The Shaw Group last summer, and while shares initially fell, CBI has actually been quite the bull recently, gaining 15.5% over the past month.
Post-deal, the company expects to have a near $30 billion order backlog. Pro-forma revenue eclipsed $10 billion last year, and Shaw's focus on nuclear power plant construction is a boon to CBI's outlook. The company trades at a price-to-earnings growth multiple below 1.0, and the sell-side expects EPS expansion to speed up over the next five years. Consensus forecasts annual growth of 18.3% a year, above the 16.5% growth rate CBI has averaged since 2007.
Balyasny's second-largest stock pick is also a small-cap: SM Energy Co. (NYSE:SM). SM Energy is an oil and natural gas E&P, with operations in the Gulf, the Permian Basin, the Rockies and the Mid-Continent region. Shares of SM have already gained over 6% since the start of the year, and investors are excited about the company's prospects in the liquids arena, particularly in Texas. The stock does trade at an elevated forward P/E of 33x, but analysts expect bottom line growth to be a whopping 76.8% over the next year.
Moving on to small-cap pick No. 3, sitting at eighth in Balyasny's 13F portfolio, we have Walter Energy, Inc. (NYSE:WLT). Walter is down quite a bit over the past year - about 36% - but the company's acquisition of Western Coal should give the coal company a greater presence in Canada and the emerging markets. Wall Street's average price target on the stock is $39.69, representing about a 6% upside from current levels. The company should report its Q4 FY2012 earnings late next month, and after missing consensus in four straight quarters, we'll be watching the date closely.
The hedge fund manager's next largest small-cap stock pick is Penn National Gaming, Inc. (NASDAQ:PENN), sitting at No. 24 in his portfolio. The casino operator announced that it would spin off its properties into the world's first REIT of its kind, and hopes to work with its peers to take on excess assets. Upon approval of the proposal, Penn shareholders will receive shares of the REIT on one-to-one terms. REIT shareholders will also receive a special dividend payout of somewhere in the neighborhood of $15 a share, split 35/65 in cash and stock. While shares of Penn itself have been up 34% over the past two months, they still trade at a decent 17.6 times forward earnings; consensus expects EPS to jump 22% over the next year.
Last but certainly not least, Balyasny's fifth largest small-cap holding is International Game Technology (NYSE:IGT), two spots behind Penn National. The slot machine and software maker fell off a proverbial cliff last July when it missed third quarter earnings by five cents (18.5 percentage points). After dropping from above $15 a share to the $11 range, IGT has slowly made its way back, and now trades just 50 or so cents below its six-month high.
The company reports its first-quarter earnings next week, and the Street is expecting an EPS of 24 cents on the back of $525 million in revenues. Both of these numbers represent double-digit growth from one year earlier, and the stock still trades at a forward P/E below 12x. If IGT can meet or beat estimates, investors could see a nice short-term value-based appreciation.
Over the longer run, we like pairing International Game Technology with Penn National - as Balyasny has done - to gain exposure to the casino and gaming industry. S&P expects this area of the economy to improve in 2013, and perceives "a trend toward gaming machines being increasingly allowed at U.S. racetracks and other venues." This undoubtedly helps IGT in particular, making it a good addition to any ardent investor's portfolio.