By Jake Mann
In the hedge fund world, money managers gain a significant portion of their alpha from stocks in the small-cap space, primarily because there is less efficient publicly available information about the little guys. We've empirically tested this phenomenon, and according to our analysis, hedge funds' top small-cap picks generate an alpha of about 120 basis points per month. We started publishing a quarterly newsletter at the end of August, and since then, until the end of December, this strategy returned 14.3% vs. 2.1% for the S&P 500 index (learn more about our small-cap strategy).
Let's focus on one hedge fund billionaire in particular: T. Boone Pickens' BP Capital. Using our database of 13F filings from the SEC, we'll take a look at the fund's small-cap holdings (see T. Boone Pickens' full equity portfolio). Each had a market capitalization between $1 billion and $5 billion at the end of the third quarter of last year, which is the same criterion used in our market-beating strategy.
SandRidge Energy Inc. (NYSE:SD) is Pickens' top small-cap pick, sitting at the No. 10 spot in his 13F portfolio. SandRidge has been a relatively poor investment over the past twelve months, but are up more than 13% since the start of the year. Much of the bullish sentiment behind shares of SD looks to be twofold. First, anticipation of the company's Q4 FY2012 financials-SandRidge has beaten the Street's top-line forecasts in at least five consecutive quarters-is likely in the minds of many investors.
More importantly, though, the stock has been lifted by SandRidge's battle with hedge fund TPG-Axon, which is seeking shareholders' approval to replace the company's existing board. Positive price action in recent weeks suggests that the markets are hopeful for a TPG-Axon victory, which would support the notion of a move to stimulate value creation.
In the hedge fund's letter to SandRidge shareholders, TPG-Axon cited a number of reasons why investors should sign its consent card. The most notable are: (1) poor performance since SandRidge's 2007 IPO, (2) the "worst credit rating" amongst its peers, (3) an inability to "focus" on one strategic initiative, (4) a "wasteful" cost structure, and (5) above-average executive compensation.
From a valuation standpoint, SandRidge trades at a mere 5.2 times cash and 1.3 times book, which is below notable peers like Anadarko Petroleum (NYSE:APC) (15.7x, 1.9x) and EOG Resources (NYSE:EOG) (30.8x, 2.5x). Still, TPG-Axon argues that this discount is for a reason, and believes that its proposals are the only way that shareholders can achieve fair value. Joining T. Boone Pickens in SandRidge is a host of other mega-hedge fund managers, including Prem Watsa and Steven Cohen (check out Cohen's favorite stock picks). It remains to be seen how this battle will play out, but it's clear what side Mr. Market is betting on.
Next up, we have McMoRan Exploration Co (NYSE:MMR), which is Pickens' second favorite small-cap stock. Freeport-McMoRan (NYSE:FCX) acquired the deep-sea driller in December, which had originally initiated a MMR spinoff nearly two decades ago. In the time since the deal, shares of McMoRan Exploration have risen by close to 90%, making Pickens millions in the process. At the end of the third quarter-the last 13F-filing period we have on record-the billionaire held approximately $3.9 million worth of MMR stock, meaning that he has made a cool $3.5 million in seven weeks' time. That's that definition of a "smart money-play."
Pickens' final small-cap holding in his 18-stock portfolio is Arch Coal Inc (NYSE:ACI), the second largest producer of coal in America. ACI investors have obviously been less than enthusiastic about bargain-basement prices in the natural gas industry, but S&P notes that "guaranteed volume contracts at pricing above prevailing rates" in coal can offer some comfort.
At severely depressed sales (0.4x), book (0.5x) and cash (2.5x) multiples, there's clearly a value play here, and Wall Street's average price target signals a 10-11% upside from current levels. A decent dividend yield of 1.5% should also draw in some income-seeking investors looking for a way to play a coal rebound for the remainder of 2013.