Focus on Einhorn's Best Choices

 | Sep 25, 2013 | 4:00 PM EDT
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David Einhorn is one of the best hedge fund managers to track. Einhorn's Greenlight Capital has returned 19.5% since its inception in 1996 (as of July 2013), and more importantly, its market beta is near 0.5.

As discussed earlier this year, Einhorn's true stock-picking skill lies in the small-cap space. Our research found that imitating Einhorn and Greenlight's entire 13F portfolio would have yielded some success. But the best alpha was found when we looked at their small-cap stocks (market caps less than $5 billion). Between 1999 and 2011, Einhorn's picks in this space returned 1.34% per month. The market returned 0.25% a month over this time.

This fundamental understanding, that hedge funds' small-cap picks give piggyback investors the best opportunity to generate outperformance, is the cornerstone of our quarterly newsletter's investment strategy (which beat the market by 29 percentage points in its first year).

With that in mind, the practical thing is to look at how Einhorn's top five small-cap picks have performed since his last 13F filing in mid-August. In order of largest to smallest, these picks were: Aspen Insurance (AHL), Babcock & Wilcox (BWC), DST Systems (DST), IAC/InterActiveCorp (IACI) and Legg Mason (LM).

Insurance and reinsurance provider Aspen Insurance has returned 2.1% since August 15. Einhorn's conviction in this stock is strong; it represents the 12th largest holding in his equity portfolio and it's been in his top 25 since the end of 2010.

Babcock & Wilcox, an energy component construction company, is up 11.0% over this time. According to Greenlight's latest 13F, this company sits one spot behind Aspen Insurance in terms of position size. Babcock was a new stake for Einhorn in the third quarter of last year, and it has been in his equity portfolio ever since.

Software service provider DST Systems, Einhorn's third-largest small-cap pick, has returned 5.6% since August 15.  The hedge fund manager first bought shares of DST at the end of 2011. Aside from Matt Sirovich and Jeremy Mindich at Scopia Capital, Einhorn's the only manager with a position larger than $50 million of the funds we track.

IAC/InterActiveCorp and Legg Mason, meanwhile, are up 6.4% and 3.4% respectively since Einhorn's last 13F filing. IAC received a 300% boost in size from Greenlight last quarter after it established the position in the first quarter of this year.

Legg Mason, on the other hand, has been a key part of Einhorn and Greenlight's relatively-limited financial exposure much longer, since the third quarter of 2011. Just 7% of the hedge fund's equity portfolio is invested in the financial sector and about a fifth of this sliver is dedicated to Legg Mason.

Here's the most important statistic of all, though. The S&P 500 ETF (SPY) gained 2.6% during this same 40-day period that we've discussed above. This means that on average, Einhorn's top five small-caps outperformed the SPY by 3.5 percentage points in a little over a month. It can be very beneficial to pay attention to hedge funds' best picks.

Last weekend we published an article here on Real Money showing that Steve Cohen's best stock picks outperformed the SPY by nearly 8 percentage points in less than a month. In this article we have shown that Einhorn's best picks outperformed the market by 3.5 percentage points in a little over a month.

Hedge funds do a lot of things wrong, like charging humongous fees or investing in well-known mega-cap stocks. If you can avoid these mistakes and focus on hedge funds' best stock picks, you can not only outperform the market by also keep all of your profits to yourself.

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