By Matt Doiron
While we don't recommend blindly following hedge funds' stock picks (as disclosed in quarterly 13F filings) in most cases, we also reject the belief held by many investors and market watchers that for one reason or another 13Fs are useless sources of information. Our research has shown that it's possible to develop and implement investment strategies based on these filings- the most popular small cap stocks among hedge funds generated an average excess return of 18 percentage points per year in our back-tests. We launched a newsletter 11 months ago and started sharing the "best stock picks" of best hedge funds and these picks have beaten the S&P 500 ETFs by 33 percentage points and Russell 2000 ETFs by 25 percentage points since then (learn more about our small cap strategy).
Another potential use of 13Fs is to see how hedge funds and other major investors are generally playing specific industries or sectors. This can help investors who are looking for initial ideas in a specific area of the market to diversify their portfolio into an industry they are less familiar with, or help them identify investment themes for further research. We have gone through our database and found the five most popular basic materials stocks among hedge funds. As is conventional, oil and gas producers are considered part of the energy sector rather than basic materials.
60 filers in our database reported a position in Lyondellbasell (LYB), a specialty chemicals company. With demand for chemicals being quite sensitive to changes in the overall economy, Lyondellbasell features a beta of 2.4. Last quarter earnings increased significantly compared to the second quarter of 2012 though sales actually slipped slightly. Markets seem to be expecting little to no earnings growth in the future, in line with Lyondellbasell's recent revenue results, as shown by the trailing earnings multiple of 12. With a dividend yield of nearly 3% as well it might be worth a closer look.
Environmental activist boogieman Monsanto (MON) was hedge funds' second favorite basic materials company as 59 of them were long the genomics and associated agricultural chemicals company. While recent results have shown little change in the company's financials compared to a year ago, investors are optimistic about the prospects of genetic engineering given the growing world population. Monsanto, a leader in the area, is valued at 21 times its trailing earnings which does seem pricy given recent performance. Billionaire Stephen Mandel's Lone Pine Capital disclosed ownership of 6.2 million shares of the stock (find Mandel's favorite stocks).
W.R. Grace (GRA), a chemicals company which specializes in "cracking" catalysts used to convert crude oil into transportation fuels, was another top pick in the sector. Sales have been down slightly, but this has been compensated for by lower COGS and so gross profit and pretax income have been fairly stable (reported earnings are up, but only because of a special item in the prior year period). Tiger Global Management was buying W.R. Grace last quarter; that hedge fund's co-founders include Mandel's fellow Tiger Cub (and billionaire) Chase Coleman. See Coleman's stock picks.
According to our database, 46 hedge funds and other major investors owned shares of nitrogen and phosphate fertilizer company CF Industries (CF). The stock is quite cheap, trading at 9 times consensus earnings for 2014, though investors should note that Wall Street analysts are looking for the company's net income to decline next year. In Q2 2013 CF did in fact see a slight fall in its business versus a year earlier which contributed to an 18% decrease in profits. Still, we would be interested in comparing the company to its peers in the fertilizer industry.
Hedge funds' favorite miner is Freeport-McMoRan Copper & Gold (FCX), which now also has significant oil and gas interests following two recent acquisitions. The stock is down 10% year to date amid continued concerns about these acquisitions as well as poor conditions in commodity markets. This decline in price has pushed the dividend yield up to nearly 4%, though earnings have also been down and the payout ratio is in the vicinity of 80% (which may indicate dividend cuts in the future). The forward P/E is 10, suggesting that analysts see Freeport-McMoRan recovering decently next year.