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There are more than 300 takeover rumors every year. The stocks that were the subject of takeover rumors initially jump by an average 2.9% but lose 1.2% in the following month. The reason is simple: Only about 15% of takeover rumors are real and the remaining 85% are just speculation. We previously discussed a strategy that will return 22% annually by shorting takeover rumors.

Shorting takeover candidates is indeed a good strategy. It is also possible to improve this strategy by excluding stocks that are more likely to be takeover candidates. One way of doing this is excluding takeover candidates that are favored by top hedge funds. Hedge fund managers may know something about a potential takeover, or they just think it is great stock to own. In either case, it is probably better not to short these names.

The Street recently published a list of 21 retail stocks that are takeover candidates. Here is what our favorite hedge funds think about these stocks:

1. BJ’s Wholesale Club (NYSE:BJ): There were 11 hedge funds with at least $1 Million invested in the company. They have a total of $224 Million in this name. Steve Cohen’s SAC Capital has the largest position in BJ.

2. dELia*s (NASDAQ:DLIA): There were two hedge funds with at least $1 Million invested in the company. Considering that DLIA’s market cap is only $56 Million, this is pretty significant. Jim Simons’ Renaissance owns 1% of DLIA’s outstanding shares. Chuck Royce’s Royce & Associates has nearly 9% of the company. Whitney Tilson’s T2 Partners is extremely bullish about DLIA, with nearly 10% of the outstanding shares. We don’t think it is a good idea to short DLIA because of potentially false takeover rumors.

3. Sears Holdings Corp (NASDAQ:SHLD): There were seven hedge funds with at least $1 Million invested in SHLD at the end of December. Eddie Lampert has a huge stake in Sears, totaling $3.55 Billion. Bruce Berkowitz also had a $1+ Billion in the same name. Stephen Mandel’s Lone Pine Capital had a $225 Million put position in SHLD. Andrew Sandler also had a $12 Million put position in this name. Considering that larger firms are less likely to be taken over, we don’t think SHLD is a serious takeover candidate.

4. GameStop (NYSE:GME): GameStop gained 25% over the past four weeks. Considering the size of the jump in shares, the rumors might be true this time. There were 11 hedge funds with at least $1 Million invested in GME at the end of December. Phill Gross’ Adage Capital had a $158 Million position in GME. Nearly 11% of GME’s outstanding shares are owned by prominent hedge funds. We don’t think it’s a good idea to short GME at this point; it might be a good idea to go long.

5. Big Lots (NYSE:BIG): Big Lots is officially on sale and the stock price went up by nearly 25% before the news became public. Hedge funds didn’t have huge positions in this name at the end of December. Ranjan Tandon’s Libra and Steve Cohen’s SAC had around $20 Million invested in this name at the end of 2010.

6. OfficeMax (NYSE:OMX): Investment banks Morgan Stanley and JP Morgan think OMX can be a buyout candidate. The stock lost more than 20% since the beginning of this year. Nine hedge funds own nearly 6% of OMX’s outstanding shares. Phill Gross and Patrick McCormak are the two biggest holders with nearly 4% of the company. Since the stock price didn’t pop after the rumors, we don’t think it makes sense to short this name.

7. Saks (NYSE:SKS): There were five hedge funds with at least $1 invested in SKS at the end of December. Diamondback Capital had the largest position in SKS. These five hedge funds collectively own 2% of the SKS’ outstanding shares. We don’t think the takeover rumors about SKS are credible.

8. JC Penney (NYSE:JCP): This is another stock recommended by Morgan Stanley as a takeover candidate. There were 14 hedge funds with at least $1 Million invested in JCP at the end of December. Bill Ackman’s Pershing Square had $1.26 Billion in JCP and he has made very bullish comments about JCP since then. Fisher Asset Management, Tremblant, and Owl Creek are among other investors with JCP positions. Bill Ackman expects JCP to double, so we don’t think it’s a good idea to short this name either.

Source: Hedge Funds' Favorite Retail Takeover Targets