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By Meena Krishnamsetty

Hedge funds as a group have been underperforming the S&P 500 index for a very long time, and this doesn't sit well with investors. The reason is simple. Investors don't really know that hedge funds are hedged. Hedge funds can't beat the market because most hedge fund managers aren't good short-investors and their long positions usually don't outperform the market by a large enough margin to make up the short fall. So, in general it isn't a brilliant idea to invest in an average hedge fund.

However, there are still two ways of taking advantage of the investment prowess of hedge fund managers. Our research has discovered that the most popular stocks among hedge funds have historically outperformed the S&P 500 index by 18 percentage points per year. This sounds impressive - but we also wanted to see whether these historical results would persist. So we launched a newsletter at the end of August and shared the stock picks of this strategy. Our stock picks gained more than 35% since then vs. S&P 500 index's 12% return (see the details here).

Another way of investing in hedge funds is picking hedge fund managers with outstanding track records. We recently came across an under-the-radar hedge fund manager who can produce alpha both on the long side and the short side of his portfolio. Our quantitative analysis shows that his alpha is even slightly better than David Einhorn's alpha.

Michael Castor of Sio Capital Management, LLC is a medical doctor (he used to be a surgeon) by training, but switched to finance in mid 2000. He worked as a healthcare analyst at JP Morgan and Bernstein Investment Research and Management until he launched Sio Capital in 2006. Academic studies have shown that small hedge funds and hedge funds focusing on a specific sector perform better than other hedge funds. Sio Capital returned 10.4% a year since its inception vs. 3.8% average annual gain for the S&P 500 Total Return Index during the same period. But this isn't why we like Sio Capital. We like Sio Capital because it achieved a 6.6 percentage point outperformance with a nearly market neutral portfolio. Its beta was 0.15 since inception. Sio Capital was also 12% net short in 2012, yet it returned 14.9% after fees and expenses.

This is what we call alpha.

One of Michael Castor's favorite large-cap stock picks is Cardinal Health (NYSE:CAH), a drug distributor. Cardinal will benefit from the wave of branded drugs going generic because distributors make more from distributing a generic prescription than a branded one. We should note that Wall Street is quite bearish about Cardinal but billionaires Andreas Halvorsen, Steve Cohen, and Ken Griffin are among CAH shareholders. Here is what Castor said about this stock in a recent interview with Insider Monkey:

The valuation of Cardinal is attractive, trading at about 12 times. Cardinal has an overhang in that a large contract with CVS is up for renewal. Cardinal distributes what's known as 'bulk' product to CVS, meaning huge crates of drugs to central locations. This is in contrast to the work Cardinal does for individual drug stores, where the company will drop off small volumes of drugs as the pharmacy needs them. In the case of 'bulk', CVS does the work of redistributing products to the individual store branches. Because Cardinal is simply delivering large crates, the mark-up and profit is small. So, on a revenue basis it looks like it's a big chunk of revenue that is at risk, but on an earnings basis it's much less significant.

Castor says he thinks Cardinal has a good chance of renewing the contract. And if it doesn't, Castor says it's not a significant impact to the stock's earning power and valuation. "It's a great stable business. It's a tremendous cash flow generator and so the combination of attractive valuation, an investment story that just makes sense to me, expectation of meeting their earnings targets and potentially even upward revision to their earnings estimates on the removal of this overhang, that constellation of factors makes Cardinal my favorite investment right now. My favorite large cap," he added.

The contract renewal should be announced any day. Castor acknowledged that the loss of the CVS contract would be negative for investor sentiment and indicated that he has purchased PUT options for protection against his losses.

Michael Castor also has large positions in Carefusion (NYSE:CFN), Covidien PLC (NYSE:COV) and GlaxoSmithKline PLC (NYSE:GSK).

Michael Castor's favorite small-cap idea performed extremely well since our interview. NPS Pharmaceuticals (NASDAQ:NPSP) returned more than 25% over the last month. Here is Castor's investment thesis:

NPS has three legs that really underpin their revenue. The first one is a set of royalties that they get with the biggest being on Sensipar, a drug sold by Amgen. It's a very stable drug that generates about $90 million of revenue for NPS on an annual basis and will continue to do so until the drug goes generic around the 2017/2018 timeframe.

The second source of revenue is a drug that is just now being launched for an indication called short bowel syndrome. This condition is what's known as an orphan disease. The condition can occur for a number of reasons. Some patients have experienced trauma such as a gunshot wound to the abdomen; others need to have a lot of their intestine surgically resected due to various diseases. In any case, patients are left with a short stub of intestine. Because it's so short they can't absorb enough food. Food passes right through their intestine. As a result, they need to be on IV nutrition. It's called TPN or Total Parenteral Nutrition.

The NPS drug that has just been approved is called Gattex and it causes proliferation of the lining of the intestines. This means the lining has more absorptive surface area and which allows them to cut down on their IV nutrition and even potentially wean off of it completely.

For people who are on IV nutrition or TPN, it's an awful thing from a quality of life perspective. They need to be hooked up to a machine throughout the entire night. Not only do patients not sleep well and just feel generally bad, TPN ends up being harmful to their liver. The prospect of weaning off of this would be a meaningful lifestyle changer for these people.

Gattex has just been launched. Looking out about five or six years into the future, I anticipate that this will generate revenues of about $300 million or so annually. I think there's the potential for it to be even larger than that but $300 million gets me to an attractive valuation, and I can revise my forecast higher if the data supports doing so.

The last drug that is still in the pipeline is for people who have had damage to their parathyroid glands and it's actually replacement parathyroid hormone. So mechanistically it's very simple, it makes sense, it's hormone replacement for people who are deficient.

I look at these three levers and I've been impressed that NPS, unlike a lot of small companies, is very conscious of what they're spending. They had their earnings call in February and articulated a plan to keep total spending to approximately $140 million. This will cover both marketing and R&D and is far below what most of their peer companies spend. To their credit, they only need to reach a handful of doctors because they're selling in very specialized indications.

So, they're watching their cost, they're very frugal and when I put these factors together it's a young company with an established revenue stream, one drug in the pipeline, and a recently-approved novel therapy for an unmet medical need. The stock that is trading currently in the high $7 range. I think it has the potential to be worth approximately $15- so double from here.

Michael Castor also summarized his investment thesis in another small-cap stock in his February investor letter: Anacor Pharmaceuticals (NASDAQ:ANAC). He talked about the stock because it lost 12.5% of its value in February but Castor said he is long-term bullish about the stock. Here is what he said:

We had only one notable loser in the portfolio in February, Anacor Pharmaceuticals [ANAC]. This is an interesting little company that we like for the long term. We foresee four ways to win with our investment in Anacor. First, Anacor has a drug to treat toe nail fungus. This product has successfully completed two late stage clinical trials. It is safe and effective. Second, Anacor is suing Valeant Pharmaceuticals [VRX] over their competing product. ANAC had hired a subsidiary unit of VRX to develop the technology for ANAC's toe nail fungus drug, and the subsidiary allegedly used that science to develop their own drug. Winning this litigation alone could be worth more than ANAC's current market cap. Third, Anacor is developing a topical cream to treat atopic dermatitis, an itchy, painful rash most commonly found in infants. Finally, Anacor could earn a royalty of about 10% on two products that Lilly [LLY] is developing for its animal health division.

Anacor Pharmaceuticals jumped last week, bringing its month-to-date gains to 91% (it's not a typo!) Castor's only bad call since our interview was Cardinal Health, losing nearly 8% of its market value. We think it is a good long-term stock pick for conservative investors. Overall, we like Michael Castor and we especially like his small-cap stock picks. You should expect to hear his name and his successful stock picks often over the next few years.

Source: 3 Stock Picks From 'The Next David Einhorn'