By Jake Mann
If you follow the financial market at least somewhat closely, you've probably heard of the so-called "Tepper rally." The phrase was coined in September of 2010 when U.S. equities rose in the few days following hedge fund manager David Tepper's appearance on CNBC, when he remarked that the market was a "win-win" scenario regardless of if the Federal Reserve continued quantitative easing. In the time since Tepper's original comments, a dovish Fed has been a chief factor behind a 41% gain in the Dow and a 50% gain in the S&P 500.
A little over three years later, David Tepper was on CNBC again talking about the Fed's role in the stock market. The manager of Appaloosa Management told Squawk Box, "They're not tapering for a long time now… and they really have no choice," adding that the federal government's short-term budget deal won't "create the confidence you'd quite like."
Philosophically speaking, Tepper states, "My basic belief has been when you have this large QE markets go up…I do think you can get an 18 to 20 times [P/E] multiple at some point." The Dow is currently trading at a P/E of 17.3, while the S&P is at the lower range of Tepper's target, indicating he sees a high upside somewhere north of 12% above current asset prices over the next 3-4 months.
With that being said, if you're willing to take his word for it that there might be a second Tepper rally, it's worth seeing how the man himself is playing one.
The hedge fund manager's favorite stock picks can be seen here, but there's one subset of his equity portfolio that has extra market-beating potential: the small caps. Our research suggests that this area exhibits the most outperformance over the long run (read the empirical data here). Tepper's top three long-term small caps held for at least two years are as follows:
Sitting at the No. 11 spot in Tepper's equity portfolio, US Airways (LCC) has been a favorite of his since we began tracking the fund in late 2010. In recent quarters, Tepper has accumulated enough of the airliner to own over $150 million worth of its stock-almost 50% more than he owned two years ago. Although US Airways' pending merger with AMR (AAMRQ) has been delayed by the U.S. Justice Department after receiving European approval this summer, the markets don't seem to care: the stock is up almost 30% since mid-August and has gained over 50% year-to-date.
While an AMR-US Airways merger was originally set to be completed sometime last quarter, new estimates place a solution to the deal at sometime in early 2014. Wall Street is currently placing a target price of $24.78 on US Airways stock, which is a 20% upside from current levels, but anyone invested here also gets a shot at the newly merged airline, assuming a deal still goes through. In this scenario, annual revenues in excess of $40 billion are expected from the new company, making it the largest airline in the U.S., and LCC shareholders should get approximately 28% of the outstanding stock.
Judging by Tepper's long-term position in US Airways, it's not out of the question to think he'll still be bullish on the company post-merger. We'd consider Wall Street's average price target as a floor for the stock if U.S. regulators stay out of the way.
Owens Corning (OC) is Tepper's second favorite long-term small cap. The company provides fiberglass insulation and roofing products to homebuilders, and generally speaking, this sub industry has traditionally lagged overall growth in the real estate market. New home and home improvement sales have shown steady growth since hitting a trough in early 2009, and more specifically, the sell-side expects Owens Corning to generate earnings growth of 50% next year and 40% every year after that through 2018.
An additional plus surrounding Owens Corning's insulation business is that stricter energy efficiency standards in the broader housing market have increased the need for this type of material. Some figures think this trend could improve insulation usage by as much as 10% to 20%, which is something that might not be factored in Owens Corning's current share price. The stock trades at a mere 13.3 times forward earnings, so it's not exactly expensive if you're interested in playing this lagging real estate pick loved by Tepper.
Shares of the company are up 27.8% over the past 12 months, and aside from Tepper, hedge fund gurus John Griffin, David Gallo and Ken Fisher are just a few of the names who are bullish here.
Mueller Water Products
Mueller Water Products (MWA), lastly, is the third largest small-cap stock that Tepper has held for at least two years. Since holding $10 million in the water equipment company at the end of 2010, Tepper's stake has risen fivefold as of the second quarter of this year, and Mueller shares are up 42% in 2013 alone. Like US Airways and Owens Corning, there's a key macro trend behind Mueller: water infrastructure investment spending.
According to estimates by the EPA and a consortium of similar agencies, $1 trillion will need to be spent on improving water infrastructure projects in the U.S. by 2035, from water main patches to sewer improvements. This may seem like a trend that's too far off to worry about, but consider that the $1 trillion figure only accounts for upkeep and replacement costs, not growth in water demand.
It's this thesis that explains why Wall Street thinks Mueller can grow its earnings by 10% a year over the next half-decade. With free cash flow more than quadrupling last year and the fact that Mueller's payout ratio is just 33% of trailing twelve-month earnings, there's upside to the stock's 0.9% dividend yield.