A Barrel of Tasty Small-Caps

 | Feb 03, 2013 | 1:00 PM EST  | Comments
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When it comes to stocks that garner the most attention from the media and institutional investors, large- and mega-cap names tend to snag the spotlight as smaller-cap stocks fly under the radar. We believe this results in mispricing -- and it turns out that hedge funds are often successful in finding undervalued companies when they look at small-caps. We have estimated that, among hedge funds, the most popular small-cap stocks have an alpha of about 120 basis points per month. We began testing this theory in our August newsletter, listing the stocks that met this criteria, and our mock portfolio proceeded to return about 20% between early September and mid-January.

We can also turn to the picks of individual funds as free suggestions, and take a quick glance at them before we decide whether they're worthy of further research. As an example, in the most recent 13F SEC filing of billionaire Michael Price's MFP Investors, here are five stocks that (at the time of filing) had market capitalization of between $1 billion and $5 billion.

To start with, MFP reported a position of 1.8 million shares in Symetra Financial (SYA), an insurance company with a $1.9 billion market cap. In terms of valuation, this stock is quite cheap: It trades at only 10x consensus earnings for 2013, and at about half the book value of its equity. Of course, investors shouldn't buy stocks just because they are cheap. But, as with hedge-fund ownership, low price-to-earnings and price-to-book metrics are a good guide to finding attractive companies. Symetra also reported 16% year-over-year revenue growth in the third quarter of last year.

Price and his team also owned about 300,000 shares of Kaiser Aluminum (KALU), an unchanged stake from that of three months earlier. Kaiser -- which manufactures aluminum products that are used as inputs in other industries -- trades at 14x both trailing and forward earnings. Sales and net income have been higher here, as well, though revenue growth has been modest.

The fund kept its holding in Cubist Pharmaceuticals (CBST) about constant, as well, at just over 180,000 shares. Cubist is a $2.8 billion market-cap name and, much like the other companies we've mentioned, its last reported quarter saw higher revenue and net income vs. the prior year. Sales, for example, were up 16%. Wall Street analysts expect high growth over the next several years, given the five-year P/E-to-growth (PEG) ratio of 0.7. However, many investors are not convinced, as 14% of the outstanding shares are held short.

MFP cut its stake in Hudson City Bancorp (HCBK), but the stock still remained one of the fund's top small-cap picks. There is a small discount to book value here, as the stock carries a P/B ratio of 0.9, and it does pay a 3.7% dividend yield at current levels. Still, this is one pick for which financial performance hasn't been strong of late -- earnings fell 34% in the third quarter -- and we think it might be best to avoid it.

Rounding out the top five MFP small-cap picks was chemical company Huntsman (HUN). This is another cheap stock, with its trailing and 2013 earnings multiples at less than 10x, though sales have been down slightly. We would also warn investors that demand for Huntsman's products depends on the broader economy, given that it is a chemical name, so the stock has a beta of 2.2. But, as with Symetra, we think Huntsman looks like a good value prospect, and we would be interested in taking a closer look at the company.

-- Written by Matt Doiron

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