A Famed Investor's Small-Cap Picks

 | Apr 04, 2013 | 2:00 PM EDT  | Comments
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Value investor Joel Greenblatt of Gotham Asset Management is well known for his book You Can Be a Stock Market Genius and for his Magic Formula Investing. We have found through our research, analyzing our database of 13F filings, that the most popular small-cap stocks among hedge funds earn an average excess return of 18 percentage points per year.

This makes sense, since small-cap stocks receive less attention from mutual funds and the financial media, and so hedge funds should be more likely to find an undervalued stock if they do research in this valuation range. We believe that one possible application of approach is to see which small-cap stocks investors such as Greenblatt like, and investors can do further research. Here are Greenblatt's five largest positions at the end of December in stocks that have market capitalizations between $1 billion and $4 billion:

Greenblatt's 13F reported a position of about 290,000 shares in United Therapeutics (UTHR), a $3 billion market cap pharmaceutical company. A number of United Therapeutics' products focus on treatment for pulmonary arterial hypertension. Greenblatt is joined in his bullishness by the consensus of Wall Street analysts. While the trailing earnings multiple is 11, the five-year price/earnings-to-growth ratio is only 0.3, demonstrating that the sell side is expecting high earnings growth over the next several years. Recent growth numbers have in fact been good. We would note that 11% of the outstanding shares are held short.

For over a year, GameStop (GME) had been one of Gotham's top stock picks, and at the end of the fourth quarter, Gotham disclosed ownership of about 610,000 shares. The stock is up 35% in the last year, but many investors are worried about the retailer's future amid the growing shift toward digital downloads of games. As a result, GameStop is also a favorite target among short-sellers. GameStop's dividend yield is close to 4%, going by current prices and recent dividend payments, and the forward earnings multiple is 8. Cliff Asness' AQR Capital Management was another major shareholder at the end of 2012.

Deluxe (DLX), a provider of printed products such as checks and business forms, was another of Greenblatt's small-cap picks. The stock price has gained 75% over the past year, and in the most recent earnings report, the company had mid-single-digit increases from the year-ago period on both the top and bottom lines. Deluxe now trades at 12x trailing earnings. Given the combination of cheap pricing and decent financial performance, we believe that Deluxe might be worth considering as a value stock.

Gotham's filing showed a 13% increase in its stake in Express (EXPR) over the course of the quarter, to a total of about 960,000 shares. The $1.5 billion market cap retailer of apparel and accessories is another stock which is low priced in terms of its earnings multiples -- its trailing P/E is 11. The sell side is expecting high growth in the medium-term future, making for a five-year price/earnings-to-growth ratio of 0.6. Actual growth last quarter from a year earlier was considerably lower, so we would not be as bullish as the Street, but even modest growth rates could make Express a value prospect.

Greenblatt and his team owned about 440,000 shares of Tempur-Pedic International (TPX) at the beginning of January. The mattress business hasn't been doing particularly well in recent years, and in fact during the fourth quarter of 2012 a slight decline in revenue contributed to a 58% fall in net income from its levels in the fourth quarter of 2011. With a trailing earnings multiple of 29, Tempur-Pedic has quite a bit of earnings growth priced into the stock already. Given the poor business conditions, we don't believe that Tempur-Pedic is a good stock to buy.

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