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By Matt Doiron

The most popular small-cap stocks among hedge funds tend to generate significant alpha - about 120 basis points per month, per our own analysis. In our August 2012 newsletter, we disclosed which small-cap stocks had been the most popular at the end of June and those stocks proceeded to return around 14% over the next 4 months (read more about our hedge fund small cap strategy) - even though by that time the picks were obviously a little out of date. These results are not typical, but on average we do see significant outperformance by these types of stocks.

Why are smaller-cap stocks such a rich source of alpha for hedge funds? In our view, this is because stocks in this price range are less closely followed by the media and other investors, making it more likely that a hedge fund will find a mispriced stock if they set their research teams to looking for stocks at smaller market cap levels than usual. Here are four stocks that billionaire Ken Griffin's Citadel Investment Group (see more stocks Citadel owned) had in its portfolio at the end of September which had market capitalizations between $1 billion and $5 billion at that time:

The fund's top pick in this range was E Trade Financial Corporation (NASDAQ:ETFC) as Citadel owned over 27 million shares of the stock. Glenview Capital, managed by Larry Robbins, was another holder of the stock. Glenview reported a position of over 11 million shares. eTrade doesn't look like a good investment to us. Not only does the stock have a high beta at 2.3 (we imagine that the company's business picks up when the stock market is doing well), the earnings multiple is high and revenue was down in Q3 2012 from a year ago.

Griffin and his team reported a position of 24 million shares in LSI Corp (NASDAQ:LSI), a $4 billion market cap designer of semiconductors including for data storage functions. LSI's business has been doing very well. In its most recent quarterly report revenue and earnings were up at double-digit rates from the third quarter of 2011, and the P/E based on consensus for 2013 is only 11. It might be worth investigating further. Iridian Asset Management, managed by David Cohen and Harold Levy, increased their holdings of LSI during the third quarter to over 25 million shares.

Citadel also liked another semiconductor company, ON Semiconductor Corp. (NASDAQ:ONNN), increasing its stake by 19% between July and September to a total of about 23 million shares. Eric Bannasch's Cadian Capital had a similarly sized position in ON Semiconductor at the end of the quarter. As with LSI the trailing earnings multiple is high but Wall Street analysts expect a considerably better 2013. However, in this case sales have been down and this has driven the stock price down over the last year as well, against a rising market.

The fund nearly doubled the size of its position in GNC Holdings (NYSE:GNC), and owned 3.5 million shares according to the 13F. GNC has more than doubled since shortly after its April 2011 IPO, and the company has been recording very good growth numbers on both top and bottom lines. Despite this good performance - net income, for example, was up 28% in the third quarter of 2012 compared to the same period in the previous year - the trailing P/E is only 17. We would note that there is considerable short interest in the stock, but GNC might still be a better buy than peers such as Walgreen Company (NYSE:WAG). Scopus Asset Management owned 2.5 million shares of stock at the end of September; that fund is managed by Alexander Mitchell.

Source: Billionaire Ken Griffin's Most Promising Stock Picks