By Matt Doiron
Our evaluation of hedge fund returns have showed that small-cap stocks are a significant source of alpha for many funds. Because small caps receive less media attention, and because they may be ignored by many large investors, they are more likely to be mispriced. We have found that the most popular small-cap picks among hedge funds tend to have an alpha of about 120 basis points per month. We put our theory to the test in our August newsletter, listing an investment strategy that proceeded to return 14% in the fourth quarter of 2012 (read more about our hedge fund small cap strategy). We wouldn't guarantee those kind of results, but we do think that a list of small-cap picks can serve as free "suggestions" from top managers who investors can then evaluate on their own. Here are five stocks which billionaire Israel Englander's Millennium Management (see more of Englander's stock picks) owned at the end of September and which had market capitalizations between $1 billion and $5 billion at that time:
Millennium increased its stake in Ultra Petroleum (NASDAQ:UPL) by 14% to a total of 2.7 million shares. Ultra is a natural gas producer with acreage in Pennsylvania's Marcellus, Colorado's D-J Basin and Wyoming's Green River basin. Poor market conditions in natural gas have driven the stock price down 28% in the last year, roughly matching the decline in revenues, and Ultra is unprofitable on a trailing basis. Ultra was one of Marathon Asset Management's top stock picks in the third quarter of 2012.
The fund reported a position of about 980,000 shares in Macquarie Infrastructure (NYSE:MIC), a $2.3 billion market cap company operating in a variety of businesses including aircraft storage and liquids storage and handling. Macquarie Infrastructure, which pays a high dividend yield, was one of Jamie Zimmerman of Litespeed Management's favorite stocks. Analyst consensus for 2013 has the stock trading at 12 times earnings estimates. Macquarie Infrastructure is up 74% in the last year with little change in sales.
Ocwen Financial (NYSE:OCN) was another of Millennium's picks as the fund more than doubled the size of its position and owned 1.5 million shares at the end of September. Ocwen, a loan servicing company, reported revenue growth of 90% and earnings growth of 154% in the third quarter of 2012 compared to the same period in 2011. The trailing P/E is 40, but the sell-side expects continued high growth and so the earnings multiple based on expectations for 2013 is only 8. Billionaire Julian Robertson was also buying the stock (check out Robertson's stock picks).
Another stock that's more than doubled since a year ago and which Englander and his team liked was building materials company Eagle Materials (NYSE:EXP). Eagle is best known for its cement business. Growth rates have been very high here as well, and more growth is priced in at the current valuation given the trailing price-to-earnings ratio of 65. The stock's beta is 1.6, which is high but perhaps not as high as would be expected for a company so apparently tied to construction.
Millennium added to its position in United Rentals (NYSE:URI), a renter of construction and industrial equipment. The economics of demand for the company's equipment mean that United Rentals is very highly correlated to the broader market - the beta is 3.1 - and it is a popular short target as well. Point State Capital had a large position in United Rentals at the end of September. United Rentals has a similar profile to some of these other companies we've discussed: double-digit growth rates of both revenue and net income in its most recent quarterly report from a year earlier, and trailing and 2013 P/Es of 68 and 10, respectively.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Business relationship disclosure: This article is written by Insider Monkey's writer, Matt Doiron, and edited by Meena Krishnamsetty. They don't have any business relationships with any of the companies mentioned in this article and they didn't receive compensation (other than from Insider Monkey and Seeking Alpha) to write this article.