By Matt Doiron
The most popular small cap stock picks among hedge funds tend to have a monthly alpha of 120 basis points, and the small cap strategy we detailed in our August newsletter earned a return of 14% between September and December (read more about our small cap strategy). Small cap stocks can be significant sources of alpha because large investment funds cannot easily take liquid stakes in these companies (and so they tend to avoid them) while the media often gives them less coverage. Hedge funds, by turning their teams of analysts loose on small caps, are thus more likely to uncover a mispriced stock.
We don't think that investors should blindly follow hedge fund managers or any other investors, but knowing that small cap picks often outperform the broader market can be useful as investors can sift through various funds' small cap picks in search for value stocks. Here are five stocks which billionaire Richard Chilton's Chilton Investment Company owned at the end of September (these positions were disclosed in November) which had market caps between $1 billion and $5 billion at that time (see more of Chilton's stock picks):
The fund initiated a position of 1.4 million shares in W.R. Grace (GRA) during the third quarter of 2012, making the specialty chemicals company (which has since risen above a market cap of $5 billion) one of its top ten stock picks. Sales and net income were both down at the company in the third quarter of 2012 versus a year earlier, and the stock trades at 21 times trailing earnings. Tiger Cub John Griffin's Blue Ridge Capital was also buying the stock during the third quarter, reporting a position of 1.9 million shares on its own 13F filing.
Weight loss drug company Vivus (VVUS), whose lead product is in development, was another of Chilton's small-cap holdings though the fund did sell some of its shares during the quarter. There is a fierce debate in the investment community as to whether Vivus or competitor Arena Pharmaceuticals (ARNA) will become the drug of choice for the medical and cosmetic markets. 21% of the outstanding shares of Vivus are held short.
Entegris (ENTG), a $1.3 billion market cap semiconductor manufacturing products company, was another of the fund's favorite small caps with Chilton reporting a position of 5.3 million shares. GMT Capital, which is managed by Thomas Claugus, owned over 13 million shares of the stock. Entegris carries a beta of 2.7, meaning that its stock price tends to be highly correlated with the broader market, and analyst consensus for 2013 places the current price at 16 times expected earnings.
Chilton had 4.2 million shares of Marvell Technology (MRVL) in its portfolio at the beginning of October. The stock is down 45% in the last year, based on both poor business conditions and legal issues, but billionaire David Einhorn and his team at Greenlight Capital were buying and have continued (including in their recent Q4 letter) to claim the stock is a buy (find Einhorn's favorite stocks). Marvell now carries trailing and forward earnings multiples of 16 and 13, respectively, so the sell-side expects the company to recover.
Women's and girls' apparel retailer Ascena Retail Group (ASNA) rounded out Chilton's top five small cap stock picks. Sales at Ascena were up 48% in its most recent quarterly report compared to the same period in 2011, but earnings were actually down 9% as margins shrunk significantly. As with many other apparel retailers the Street believes that it has good growth prospects, with the stock trading at 11 times forward earnings estimates and a five-year PEG ratio of 0.9.