By Jake Mann
In the small-cap space, stocks don't get as much attention from the media and third-party analysts, which often leaves them less efficiently priced than their larger peers. Hedge funds take advantage of this by dedicating their research teams to work on these stocks.
Interestingly, retail investors can use hedge funds' top small-cap picks as a market-beating strategy; we've determined that the most popular small-caps among hedge funds can earn about 120 basis points of alpha per month (check out the details here).
Keeping this in mind, we're going to take a look at one fund in particular: Ken Grossman and Glen Schneider's SG Capital Management. Grossman and Schneider have a decently sized equity portfolio (see the fund's entire stock picks here); let's focus on the duo's five favorite small-cap picks. As is consistent with our strategy, each stock has a market capitalization between $1 billion and $5 billion.
Clean Harbors Inc (CLH) is SG Capital's top small-cap holding, sitting at the No. 3 spot overall in Grossman and Schneider's latest 13F filing with the SEC. Shares of the waste management company are up close to 8% over the past month on the back of its acquisition of Safety-Kleen. Safety-Kleen gives Clean Harbors a bit more coverage in the parts cleaning segment of this industry, and its oil re-refining business is one of the biggest in North America.
While the markets have already responded favorably to this deal, there may more room to run, so to speak. Shares of Clean Harbors trade at a modest 19.6 times earnings, and Wall Street's average price target on the stock represents a 22% upside from current levels. Cliff Asness' AQR Capital Management and Ken Griffin's Citadel Investment Group are two other key investors in Clean Harbors (see Ken Griffin's full 13F portfolio here).
Next up we have VCA Antech, Inc. (WOOF), sitting at the No. 5 spot in SG Capital's portfolio. As its ticker name implies, VCA is a veterinary service company that has its fingers in the diagnostic testing market as well. VCA beat earnings expectations by six percentage points in its last quarterly report, boosted by margin improvement in its Hospital and Laboratory segments.
Still, this is a stock with a valuation that isn't particularly attractive, and it has recently seen a major downgrade from Stifel Nicolaus, who cited "long-term systemic issues at the high margin lab business […] which may result in continued market share losses." VCA reports its fourth quarter earnings on February 14; we'll be watching this date closely.
RPM International Inc. (RPM) is Grossman and Schneider's third favorite small-cap stock, and has already bounced 7.8% since the start of the year. The diversified chemical manufacturer reported its Q2 FY2013 earnings on January 8, booking a slight revenue beat, and overall top-line growth of 11.1% from one year earlier. A PEG of 2.4 indicates that investors may be overly optimistic about RPM's growth prospects moving forward, but a dividend yield above 2.8% and a recent upgrade from Oppenheimer indicate that there are still reasons to be bullish.
Atlas Air Worldwide Holdings, Inc. (AAWW) is the next largest small-cap holding in SG Capital's 13F portfolio. AAWW has been a particularly volatile stock over the past year, and currently sports a beta near 2.4. The holding company's main subsidiary, Atlas Air, is an aviation services company. Atlas Air Worldwide has seen moderate annual EPS expansion of close to 5% over the past half-decade, but it's worth noting that the sell-side expects this growth to triple over the next five years.
Driving this stock is a generally positive environment for air-related service companies, which should be supported by a strengthening global economy. China, where Atlas Air began its operations in 1993, is expected to play a key role in the company's growth prospects moving forward.
Last but certainly not least, Tetra Tech, Inc. (TTEK) is SG Capital's fifth-largest small-cap holding, sitting at the No. 10 spot in the fund's portfolio. Like Clean Harbors, Tetra Tech operates in the waste management space, though the company has a greater focus on consulting and engineering services.
A willingness to expand via acquisition has many investors mixed on the company's long-range prospects, but a Q1 (FY2013) earnings beat next week is a distinct possibility. Tetra Tech has beaten consensus earnings estimates in three of its past five quarters by an average margin of 4%. While it does not pay a dividend, Tetra Tech does offer investors shares at a mere 0.9 times sales, and Wall Street's average price target reveals an 11%-12% upside is expected.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.