Billion-Dollar Activist Hedge Fund's Best 5 Stock Picks

by: Insider Monkey

By: Jake Mann

Hedge funds are able to gain much of their alpha from small-cap stocks, due to the fact that there is generally less efficient publicly available information about the little guys. At Insider Monkey, we've empirically tested this phenomenon, and according to our analysis, hedge funds' top small-cap picks beat the market by more than 15 percentage points per year.

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 in particular: Jeffrey Smith's Starboard Value. Using our database of 13F filings from the SEC, we'll take a look at the fund's top five small-cap holdings (see Starboard Value's full equity portfolio). Each has a market capitalization between $1 billion and $5 billion, which is the same criterion used in our market-beating strategy.

At the end of the last 13F filing period with the SEC, Office Depot Inc (NYSE:ODP) was Starboard Value's No. 1 holding, and is coincidentally a small-cap as well. Jeffrey Smith's history with this stock is well documented (see his biggest move here), and shares of the office supply retailer are up a whopping 33.2% since the start of the year. This appreciation is an extension of the company's blowout third quarter, in which it beat the Street's EPS estimates sixfold. An additional driving force behind this momentum has been rumors of a merger with OfficeMax (NYSE:OMX), though there are still no certainties at the moment. Excluding the prospects of an OMX deal, ODP looks particularly overvalued at the moment at 44 times forward earnings, so buyers should beware if a merger were to fall through.

Next up we have Progress Software Corporation (NASDAQ:PRGS), the business systems software company. At the beginning of 2013, reports surfaced that Progress Software would push the divestiture of its Artix, Orbacus and Orbix brands earlier than was originally planned. In layman's terms, this move is part of a longer-term shift by Progress Software to become a leaner, meaner tech player. Despite the recent run-up in stock price, shares still look cheap at a forward P/E (14.3x) nearly 60% below the software application industry's average.

Integrated Device Technology, Inc. (NASDAQ:IDTI) is Starboard Value's third favorite small-cap stock, and like the fund's first two picks, it has been a monster in recent months. Since last August, shares of IDTI are up more than 50% on the back of two consecutive FY2013 earnings beats, both thumping consensus estimates by at least 25%. Sales of the semiconductor company's RapidIO switches have benefited from a continued industry-wide 4G LTE rollout, and executives expect accelerating growth to come from China moving forward. Obviously, this tech trend isn't going away any time soon, and at a modest 1.7 times book and 21.9 times year-ahead EPS, shares don't look particularly overbought at these levels.

UTi Worldwide Inc. (NASDAQ:UTIW) is the hedge fund's fourth largest small-cap holding. Morningstar calls UTi one of the "top 20 global freight forwarders," and it appears Wall Street agrees that investors can feel safe adding the stock to their portfolios. Of the nine analysts who cover UTi, a mean target of $15.94 represents a 6-7% upside from its current share price. On the flip side, this is a company that is presently riding an 0-for-3 streak in quarterly earnings, failing to meet the Street's estimates by double-digit percentage points each miss. As can probably be expected, shares of UTi have essentially remained flat since the start of this bearish trend last June.

At PEG of 1.7 and a measly dividend yield of 0.4%, there doesn't seem to be much to currently attract value or income-seeking investors into this stock, and EPS growth this year is expected to only come in at 2.5%. Until UTi can impress with its quarterly financials-we'll have to wait until late March-it's difficult to justify an overly bullish thesis at the moment.

Last but certainly not least, we have Compuware Corporation (NASDAQ:CPWR), Starboard Value's fifth favorite small-cap stock pick. Like Progress Software, Compuware operates in the software application industry, but shares of this particular company are much more expensive than their peer, trading at a PEG above 4.0 and close to 23.0 times year-ahead earnings.

Still, shares of Compuware were up over 5% on the last Friday of January as a result of three bullish factors. In no specific order, they are as follows: (1) the introduction of a 50-cent annual dividend beginning next quarter, (2) a rejection of Elliott Management's buyout offer at $11 a share, and (3) a planned spin-off of Covisint, the company's cloud storage segment. Compuware's 3-month, 6-month and 1-year returns are all in excess of 25%, proving that investors have been handsomely rewarded by "monkeying" Starboard Value here.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: This article is written by Insider Monkey's writer, Jake Mann, and edited by Meena Krishnamsetty. They don't have any business relationships with any of the companies mentioned in this article and they didn't receive compensation (other than from Insider Monkey and Seeking Alpha) to write this article.