By: Jake Mann
In the financial world, small-cap stocks don't get as much attention from bankers, the media or third-party analysts, which often leaves them less efficiently priced than their larger peers. Hedge funds, meanwhile, seek to take advantage of this by dedicating their research teams to work on these lesser-known investments. Intriguingly, retail investors can use hedge funds' top small-caps as a market-beating strategy. Our analysis shows that the most popular small-cap stocks among hedge funds can generate close to 120 basis points of alpha per month.
But that's not all.
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 hedge fund small-cap strategy).
Keeping this in mind, it is crucial to perform a fund-by-fund analysis of this phenomenon. In this article, we're going to take a look at Ray Dalio's Bridgewater Associates. According to its latest 13F filing with the SEC, Bridgewater has an equity portfolio in excess of $7 billion (see Ray Dalio's entire 13F portfolio), but we're going to focus on the hedge fund's top five small-cap picks. Each stock had a market capitalization between $1 billion and $5 billion at the end of the third quarter, which is the same standard used in our premium strategy. Let's get started.
Sitting at the No. 7 spot in his 13F portfolio, Dalio's top small-cap holding is Safeway Inc. (SWY). Shares of Safeway have risen precipitously over the past six months - nearly 30% - as the grocer has beaten the Street's earnings estimates in two straight quarters. Generally speaking, a few factors that have contributed to this outperformance include the company's "Just for U" loyalty program, and the sale of 16 Genuardi's locations for cash proceeds of nearly $7 million per store.
Despite its recent gains, Safeway's stock price still has room to run at a mere 9.2 times forward EPS and a PEG ratio near 1.0, but a solid Q4 earnings release next month is crucial if shares are to reach a fairer value. Aside from Dalio, another hedgie who's bullish on Safeway is Cliff Asness, the manager of AQR Capital (see Cliff Asness' newest stock picks).
Ray Dalio's second favorite small-cap is Apollo Group Inc (APOL), one of the largest for-profit education companies in the world. The owner of University of Phoenix, Apollo's stock price movement mirrors investors' sentiment about the future of fee-based online education.
Simply put, with classes beginning to be offered by companies like Coursera - which partners with higher caliber universities - many students are left wondering what exactly a University of Phoenix degree is worth. Further industry fragmentation is being driven by localized efforts of schools like Harvard and MIT to offer free courses via their edX program, among others.
Still, at a PEG below 1.0 and a forward P/E under 8.0x, there is clear value in Apollo, and it's worth noting that the sell-side expects slight annual earnings acceleration over the next half-decade - 7.8% compared to 6.0% over the previous five years. There's nothing attractive about this stock for income-seeking investors, but for those willing to try to snag a market leader at a cheap multiple, APOL makes sense.
Next up we have Electronic Arts Inc. (EA), another beaten down stock over the past few years, though EA is arguably facing more secular headwinds than Apollo. Operating in a videogame industry that's seeing more competition from mobile games and that's in desperate need of next gen consoles, EA investors haven't had much to look forward to.
The sell-side does expect earnings to expand by 17% next year and 14% per year through 2017, which is at least partially a factor of EA's potential in the digital content delivery realm. If gamers do make the full switch from in-store purchases to online downloads - which has already begun - EA is prepared to go 100% digital. This scenario, coupled with a new console launch, represents the best bullish thesis for EA moving forward.
AGCO Corporation (AGCO) is Dalio's fourth largest small-cap holding, and has seen quite a bit of investor optimism in 2013. Shares are already up 9% since the start of the year, as the agricultural equipment company is set to report its Q4 FY2012 financials on February 5th. Wall Street's consensus for the quarter is soft on the earnings side - a 32% year-over-year decline is projected - and revenues are expected to be essentially flat. At 9.6 times forward EPS and a PEG below 0.7, there's clear potential for appreciation, but a strong fourth quarter will be necessary to warrant value-investors' confidence thereafter.
Last up we have Interpublic Group of Companies, Inc. (IPG), one of the world's largest advertising agencies. Unlike the other companies on this list - aside from Safeway - Interpublic pays a modest dividend yielding close to 2%, and offers decent value. IPG's earnings currently trade at a 23% discount to the ad industry's average, and book (2.4x) and sales (0.9x) multiples are cheap as well. Of the 23 Wall Street analysts that cover IPG, 18 hold buy ratings, and their consensus price target pins an upside of about 8% on the stock.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.