Following the Hedgies Pays Off, Part 2

 | Jan 08, 2013 | 10:30 AM EST
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In Monday's column we asserted that following hedge funds can produce consistent market-beating returns. We countered some arguments against this strategy and showed why hedge funds' 13F filings can be a valuable resource for the individual investor.

Today, we'll discuss a quintet of stocks that can help you achieve glory in 2013. Not surprisingly, this group consists of the five most popular stocks among the hedge funds we track. They are as follows:

1. Apple (AAPL): The proverbial top dog, Apple was the most popular stock among the 400 hedge funds we track, with 146 funds holding long positions at the end of the last round of 13F filings in the third quarter. Despite the pain that many Cupertino bulls have felt lately, we believe that Apple can have a stellar 2013, and not just because of the stock's cheap valuation.

Yes, a forward earnings multiple below 10 and a price/earnings-to-growth ratio near 0.6 are obviously attractive, but Apple also has a number of potential growth catalysts on the horizon that can boost shares to a fairer value.

The most crucial of these are a potential deal with China Mobile to deliver the iPhone 5S or a low-cost iPhone to the carrier's customers, a dividend boost, continued development of Apple's in-car "eyes free" system, an Apple TV and a smart watch.

It's quite possible that just one of these developments could pay off for value investors, and a projected dividend yield above the 10-year Treasury bonds provides a nice security blanket in the meantime.

2. Google (GOOG): Coming in second, Google had 132 hedge funds invested at the end of the third quarter, with 14 new money managers taking positions over this time. Some of the most prominent backers of this stock are Stephen Mandel and Philippe Laffont, while the most committed (as a percentage of his portfolio) is Robert Karr and his fund, Joho Capital, which holds more than 30% of its 13F assets in the stock.

While Google doesn't have quite the beaten-down valuation that Apple does, trading at a moderate forward price-to-earnings ratio near 15 and a trailing P/E in the low 20s, it still sports a near-10% discount to its industry's averages.

Aside from being constantly picked on by European officials for its advantageous tax setup across the pond, the most interesting development in Google's corner this year may be its first-ever entry into the OEM (original equipment manufacturer) smartphone space. The company's Motorola Mobility unit, dubbed the "X Phone," will play an integral role in the project and may just give Google a chance to pair its Android OS with an equally formidable piece of internally made hardware.

3. American International Group (AIG): A surprising member of this list, American International Group was truly a hedge-fund favorite in the third quarter, with a whopping 49 new funds taking positions in the insurer. When all was said and done, 110 of the hedge funds we track were long, and the total capital invested in the stock more than doubled to $12.5 billion.

On the surface, the massive interest in AIG appears to be driven by the closing of its bailout from the Treasury Department in the second week of December. It's possible that hedge funds were speculating on the occurrence of this event, and once we obtain 13F filings for the fourth quarter, we'll be sure to let you know how they behaved.

Now that the stock is free of federal overhang, general investors are now more willing to snatch up a stock that trades at a mere 0.7x sales and a PEG below 0.2.

AIG is also a leaner insurer, and sell-side analysts expect it to grow its earnings by 17% to 18% a year over the next half-decade. That's good growth at a reasonable price.

4. Microsoft (MSFT): Not many investors would call Microsoft their favorite tech stock. Still, that hasn't stopped the smart money from accumulating shares, as 96 of the hedge funds we track are bullish. While product releases of its Surface tablet and Windows 8 OS aren't generating too much excitement at the moment, Microsoft is still expected to generate better earnings growth over the next five years (9.6% annually) than it has over the past five (7.0% annually), according to analyst averages.

Trading at a mere 3.4x its cash flow, which is considerably below both Google (5.2x) and Apple (17.5x), Microsoft offers obvious value. Even more importantly, a benefit to many hedge funds is that Microsoft pays a projected yield of 3.4%, with a steady history of dividend increases.

5. Citigroup (C): Last but certainly not least, Citigroup is the fifth most popular stock among the hedge funds we track, with 93 money managers bullish at the end of the third quarter. This banking giant is expected to see its top line grow by 8% over the next year, and double-digit loan growth looks to be on the horizon.

A global network gives Citigroup an obvious advantage over many of its more U.S.-focused peers, and the sell side expects better earnings growth over the long run (a five-year average of 11.0%), compared with JPMorgan Chase (JPM) (7.3%) and Bank of America (BAC) (7.9%). While leadership concerns remain, shares of Citigroup have actually gained 12.9 percentage points since Vikram Pandit resigned as CEO last October.

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