Hedge Funds Are Buying These 3 Undervalued Mid And Small Caps With Encouraging Dupont Trends

Includes: MKL, OFC, VDSI
by: Kapitall

Do you like to follow smart money buying trends? If so, you may be interested in our list of undervalued stocks with strong sources of profitability that are currently favored by institutional investors.

We began with a universe of stocks that appear undervalued relative to EPS trends. Based on the theoretical assumption that if P/E is equal to a constant K, growth in EPS estimates should be matched by proportionate growth in price. When they don't match up, a mispricing may have occurred. We screened for those exhibiting this mismatch between changes in EPS estimate and price.

Next we screened for stocks with bullish sentiment from institutional investors, with significant net institutional purchases over the last quarter representing at least 5% of share float. This indicates that institutional investors such as hedge fund managers and mutual fund managers expect these names to outperform into the future.

We then looked for stocks with an encouraging DuPont breakdown. The DuPont formula uses return on equity (ROE) to measure profitability. The higher the ROE, the more profitable the company appears, but this profitability can come from many sources - some better than others.

Generally, an encouraging DuPont breakdown implies one or more of the following:

-Improving Net Profit Margin, i.e. higher Net Income/ Revenues
-Improving Asset Efficiency, i.e. higher Sales/Assets
-Decreasing Financial Leverage ratio, i.e. lower Assets/Equity

Therefore, companies passing these requirements are experiencing increasing profits due to operations and not because of increased use of leverage.

The List

For an interactive version of this chart, click on the image below. Analyst ratings sourced from Zacks Investment Research.

Do you think hedge funds are making the right call with these stocks? Use this list as a starting point for your own analysis.

1. Markel Corp. (NYSE:MKL): Markets and underwrites specialty insurance products and programs. It operates in three segments: Excess and Surplus Lines, Specialty Admitted, and London markets.

  • Market cap at $5.06B, most recent closing price at $525.33.
  • Net institutional purchases in the current quarter at 920.5K shares, which represents about 10.79% of the company's float of 8.53M shares. The 2 top holders of the stock are Baillie Gifford and Company and The Vanguard Group, Inc.
  • MRQ net profit margin at 10.84% vs. 7.81% y/y. MRQ sales/assets at 0.062 vs. 0.062 y/y. MRQ assets/equity at 3.16 vs. 3.292 y/y.

Markel's acquisition strategy has been quite successful, and Zacks reports the company's recently completed $3 billion buy of Alterra Capital Holdings is projected to improve Markel's debt to capital ratio by 100 basis points to 27%. Additionally, Property Casual 360 writes that with the acquisition, Markel is now the fifth-largest Excess and Surpluss insurer in the U.S. with roughly $1.06 billion in premiums.

The insurer also benefits from CIO Tom Gayner's knack for investing shareholder equity with consistently impressive returns. The Motley Fool writes that Markel has become a 21-bagger under Gayner's guidance, and now with the added capital from the Alterra acquisition, Gayner is finally free to invest the company's float.

2. Corporate Office Properties Trust (NYSE:OFC): Engages in the acquisition, development, ownership, management, and leasing of suburban office properties.

  • Market cap at $2.51B, most recent closing price at $29.21.
  • Net institutional purchases in the current quarter at 6.1M shares, which represents about 7.16% of the company's float of 85.14M shares. The 2 top holders of the stock are The Vanguard Group, Inc. and Cohen & Steers Capital Management, Inc.
  • MRQ net profit margin at 9.67% vs. 7.78% y/y. MRQ sales/assets at 0.036 vs. 0.035 y/y. MRQ assets/equity at 2.506 vs. 3.393 y/y.

Almost 70% of Corporate Office Properties Trust's annualized rent comes from properties rented by government agencies or defense contractors. Consequentially, the company is particularly vulnerable to sequestration, which, per the Wall Street Journal, has made investors apprehensive of the stock. The specialty office real estate trust also has to contend with elevated lease expirations as almost 45% of its agreements expire by the end of 2015

Nevertheless, 89% of lease renewals during the first quarter of 2013 came from the aforementioned tenants, and the average lease renewal term of 5 years is the highest it's been in 2.5 years. The company is also in the final year of its Strategic Reallocation Plan (SRP), which launched in 2011; through the plan, Corporate Office Properties Trust aims to sell off its non-core assets. Fitch reports the SRP led to a leverage reduction to 7.0x at December 31, 2012 from 8.6x at December 31, 2011. The ratings agency expects further de-levering through continued asset sales.

3. VASCO Data Security International Inc. (NASDAQ:VDSI): Developed patented digital security hardware, software, and digital-signature technology.

  • Market cap at $333.3M, most recent closing price at $8.44.
  • Net institutional purchases in the current quarter at 1.5M shares, which represents about 5.28% of the company's float of 28.39M shares. The 2 top holders of the stock are FMR LLC and Killen Group, Inc.
  • MRQ net profit margin at 7.89% vs. 5.92% y/y. MRQ sales/assets at 0.191 vs. 0.187 y/y. MRQ assets/equity at 1.177 vs. 1.226 y/y.

At the beginning of the month, The Street upgraded its rating for VASCO Data Security International to a buy, citing the company's better than average revenue growth of 1.4%, a quick ratio of 4.77, and a debt-to-equity ratio due to the company's lack of debt. The company has benefited from increased demand from the banking sector as reflected by the 19% increase in revenue from the first quarter of 2013.

Last quarter, VASCO saw a 21% decrease in sales from the Enterprise and Application security market. The company's management expressed interest in the most recent earnings call in working with companies to combat hacking, but it has yet to make any progress in that area. There is some positive news on the Enterprise and Application security front, although its impact remains to be seen. Earlier today, VASCO announced that HSBC Brazil is offering the software security company's Digipass for Mobile technology to its customers. With this development, HSBC Brazil is the first and only financial institution with fully integrated access to online banking, mobile services, contact center, ATMs, and e-commerce.

*Accounting data sourced from Google Finance. EPS data sourced from Yahoo! Finance. Institutional data sourced from Fidelity. All other data sourced from Finviz.

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

Business relationship disclosure: Business relationship disclosure: Kapitall is a team of analysts. This article was written by Mary-Lynn Cesar, one of our writers. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.