Fishing for Small-Cap Jewels

 | May 31, 2013 | 3:00 PM EDT
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We have been live-testing our strategy of buying small-caps that are especially popular among hedge funds, per 13F filings, and this strategy has returned 47% since September. Those kinds of results aren't out of the ordinary, either: Our research shows that such small-caps outperform the broad market by an average of some 18 percentage points per year. (We define small-caps as stocks with market capitalization between $1 billion and $5 billion.)

Institutional investors, such as mutual funds, don't tend to own small-cap stocks quite as frequently as bigger names. As a result, it would appear that those shares are more likely to be either undervalued or overvalued -- thus explaining their collective outperformance. Individual managers' favorite small-caps, then, may serve as intriguing sources of initial investing ideas.

So let's go over the five largest small-cap holdings at Richard Chilton's hedge fund at the end of March.

First, the fund owned 4.7 million shares of chipmaker Atmel (ATML), whose profits have been quite low on a trailing basis, and sank 8% in the first quarter. Analysts do expect that business will rebound over the next year and a half, and the forward price-to-earnings ratio is 13x. But we're skeptical of their optimism, and apparently investors are, as well -- because, even against a rising broad market, Atmel shares have retreated in the past year.

Next up is Chilton's 470,000-shares stake in DineEquity (DIN) -- though he and his team have recently cut that holding by more than 40%. DineEquity, which operates the Applebee's and IHOP restaurant chains, recently began paying out a quarterly dividend of $0.75 per share, which makes for a yield of more than 4% at current prices. That may make it appealing to income investors, though the company had previously suspended its dividend payment in 2008. DineEquity trades at 17x forward earnings estimates, which is high for a table-service restaurant in the current market environment.

But quick-service restaurants such as Domino's Pizza (DPZ) are investor darlings, and that particular stock is currently valued at trailing and forward P/Es of 28x and 22x, respectively. Chilton picked up Domino's in the first quarter and reported a position of about 600,000 shares at the end of March, making it one of the fund's top small-cap picks. While earnings have been up at the company, we don't think the recent bottom-line growth rate is sustainable, particularly given the more moderate sales climbs. As a result, we're skeptical that Domino's will in fact manage to justify its current valuation.

Genesco (GCO), a retail name with a $1.7 billion market cap, also made our list of Chilton's favorite small-cap stocks. Genesco -- which owns the Journeys, Schuh and Lids chains, among others -- suffered declining income in its January quarter, though sales rose 10%. The sell side is expecting Genesco's profit to begin rising in fiscal 2015 (ending January 2015), as consensus forecasts place the stock's valuation at 11x earnings estimates for that fiscal year. So we don't like the recent earnings decline, but we would certainly be interested in comparing Genesco with its peers.

Rounding out our list is First Horizon National (FNB), a regional bank operating in Tennessee. First Horizon carries a small premium to the book value of its equity, with a price-to-book ratio of 1.2x. The bank is unprofitable on a trailing basis, thanks to a poor second quarter last year. This year, analysts expect earnings per share of $0.78, a figure that implies a P/E of 15x. Income has been up strongly, as well. So, while the stock a bit above where many other banks are trading, First Horizon might be worth investigating further.

-- Written by Matt Doiron



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