By Matt Doiron
Billionaire David Einhorn of Greenlight Capital is one of the most closely followed hedge fund managers in the media. We've done some research on Einhorn's portfolio over time, and we're going to tell you his secret: he actually gets a large portion of his alpha from small cap picks rather than the big names which dominate financial media coverage. This is true for hedge funds in general as well. In fact, the most popular small cap stocks among hedge funds generate an average excess return of 18 percentage points per year (learn more about our small cap strategy) and our own portfolio based on these results beat the market by 33 percentage points in the last 11 months. We have gone through Greenlight's most recent 13F (available in full on the SEC's website) and here are its five largest positions in stocks with market capitalizations between $1 billion and $5 billion as of the end of June:
Oil States International (OIS) was one of Einhorn's ten largest 13F holdings at the end of the quarter. The company includes an attractive accommodations business serving oilfield workers, which activist Barry Rosenstein of JANA Partners believes could be spun out as a real estate investment trust. Since REITs are more tax efficient, this transaction would create shareholder value above the standard benefits of spinouts. With Oil States trading at 13 times trailing earnings, the bar for any value creation is set fairly low- though we would note that reported sales and net income have been down recently.
Greenlight reported a position of 3.9 million shares in Aspen Insurance Holdings (AHL), a $2.5 billion market cap reinsurance and property and casualty insurance company. In the second quarter of 2013, the company's revenue was up slightly versus a year earlier but with higher loss expenses as well both operating and net income have fallen. The stock is at least priced close to value territory, with trailing and forward P/Es of 13 and 11 respectively, though even at these levels we would want to see good prospects of EPS growth before considering Aspen as a potential buy.
Babcock & Wilcox (BWC) was another of the fund's small cap picks. The machinery company specializes in components for nuclear power systems and other power plants, and therefore serves both utilities and the U.S. Navy. While business has been stable recently, Wall Street analysts are predicting high earnings growth over the next several years; as a result, at the current valuation, the forward earnings multiple is 12 and the five-year PEG ratio is 0.7. There's a fair amount of short interest, but even so it might be worthwhile to research why the sell-side is so optimistic about the future.
Einhorn and his team disclosed ownership of 1.7 million shares of $3.2 billion market cap information processing and communications software company DST Systems (DST). DST's operating income has been up- though this has been primarily driven by widening margins, which may not be sustainable- with reported earnings down on lower income from other sources. Analysts expect a little over $5 in EPS in 2014, which comes out to a forward P/E of 15, but we'd have to look into the details of the company's non-operating earnings and that valuation is not that low in any case.
Rounding out our list of Greenlight's top five small cap picks is IAC Interactive (IACI), the owner of ask.com, match.com, and other online properties. With business improving in the search segment and the company successfully cutting corporate expenditures, both revenue and earnings grew at double-digit rates last quarter compared to the second quarter of 2012. IAC is another case where analysts are quite bullish: the trailing and forward P/Es are 24 and 11, respectively, and the five-year PEG ratio is considerably less than 1. Given recent results, it also appears to be worth a closer look.