David Tepper’s 5 Promising Stock Picks

Meena is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

In the hedge fund world, there aren't many money managers who are as prophetic as David Tepper. Tepper's fund, Appaloosa Management, manages close to $16 billion in assets and returned 25% last year after fees (through Dec. 17th). Clearly, any financial professional that has Carnegie Mellon’s business school named after them by the age of 55 is someone to pay close attention to. Last month, we discussed Tepper's prediction that equity markets have "a lot" of upside in 2013, and the Fed's continued monetary stimulus creates a scenario with "very limited downside" (see 5 Stocks You Can 'Tepperize' Your Portfolio With in 2013).

Tepper's entire 13F portfolio can be seen on his profile page at Insider Monkey, but we're going to take a focus on the hedge fund manager's most promising stock picks in the small-cap space. Generally speaking, hedge funds' small-cap investments are much more successful than their large-cap picks, which is a phenomenon we've seen across the majority of the industry's key players.

Between 1999 and 2009, our "small-cap strategy,” which follows the most popular small-cap stocks among the hedge funds we track, generated a monthly alpha of 120 basis points. To share these picks, we started publishing a quarterly newsletter at the end of August, and through December 31st, the strategy returned 14.3% versus 2.1% for the S&P 500 index ETF (SPY) (check out our newsletter here).

Focusing on David Tepper and Appaloosa Management in particular, we're going to take a look at the hedge fund manager's top five small-cap stock picks. This quintet is compiled through the use of Appaloosa's most recent (Q3) 13F filing with the SEC, and is listed in order of market capitalization at the end of the third quarter. In accordance with the standard definition of "small-cap," we'll focus on stocks with a market capitalization between $250 million and $2 billion. Let's get started.

US Airways Group (NYSE: LCC) was Tepper's top small-cap pick at the end of Q3, accounting for 3.53% of the fund's 13F portfolio, good for his ninth largest holding. This airline operator looks to be on the eve, figuratively speaking, of a merger with American Airlines, though nothing is set in stone. AA parent AMR Corp. is still considering its options, but American's CEO Tom Horton told The Republic earlier this week that a solution will be revealed in "a matter of weeks."

If a deal does occur, most analysts estimate synergistic cost savings at close to $500 million, and additional revenue expectations are nearly twice this figure. For a company that Wall Street expects to make a little over $14 billion in top line revenues next year, a merger would create significant upside for US Airways shares. The stock already trades at a lowly price-to-sales multiple of 0.18, so there's an obvious value play here, even without AA. While there's currently no way for US Airways bulls to determine how their shares may be split up after a deal, the stock represents a rather intriguing 'growth at a reasonable price' opportunity.

Mueller Water Products (NYSE: MWA) was the hedge fund manager's second largest small-cap holding at the end of last quarter, just cracking Appaloosa's top 25 holdings overall. Mueller operates in a curious business, manufacturing and selling products related to the distribution of water. Within the company's mix lies fire hydrants, valves for drinking, waste and gas systems. Mueller has been especially kind to Tepper's portfolio over the past year, returning close to 112%. After finishing 2012 with earnings of four cents a share, the Street expects Mueller to finish 2013 with an EPS of $0.17, before reaching a 27-cent figure by the end of 2014. The combination of a continued U.S. housing recovery and a decaying water infrastructure should drive this excellent growth.

Calumet Specialty Products Partners (NASDAQ: CLMT), the specialty hydrocarbon producer, is Tepper's third favorite small-cap, sitting at 30th place in terms of his fund's total 13F portfolio. An MLP, Calumet currently sports a projected dividend yield near 8% at a +60% payout of earnings, which have shrank by nearly 19% a year--on average--over the past half-decade. The sell-side expects massive EPS acceleration over the next five years, though, with early forecasts expecting a 16-17% annual growth through 2017. It appears that this growth should be partially steered by lower feedstock costs. Shares have already returned 46.9% over the past 12 months, but still trade at discounted PEG (0.56) and forward P/E (8.4x) multiples.

Gaming and casino company Boyd Gaming (NYSE: BYD) is just the fourth small-cap stock in Tepper's top 45 holdings. The hedge fund manager held a little over $14 million worth of the stock at the end of last quarter, but has seen a sub-par return on his investment over the past year; shares of BYD have essentially remained flat. The bullish argument for Boyd seems to lie in its multi-jurisdictional operations, which stretch across Nevada (Las Vegas), New Jersey (Atlantic City), Illinois, Indiana, Louisiana and Mississippi. Partially due to tax-related worries, Boyd trades at undervalued metrics across the board, and after finishing 2011 with a loss of one cent per share, analysts expect the company to reach a 22-cent EPS by the end of 2013.

Last but certainly not least, JetBlue Airways (NASDAQ: JBLU) is Appaloosa's fifth largest small-cap holding, sitting 49th of the hedge fund's 54 stocks listed on its last 13F filing. JetBlue is another airline play in Tepper's portfolio, and it's worth noting that it the company said it was “not interested” in an American Airlines merger last August. Dave Barger, JetBlue's CEO, has mentioned that it is focused on "independence" in the face of industry-wide consolidation. Interestingly, the sell-side is extraordinarily optimistic on JetBlue's future, forecasting EPS growth of 28-29% a year over the next half-decade. At a PEG below 0.5, it appears that the markets aren't valuing the stock's potential properly.

Judging by David Tepper and Appaloosa Management's top five small-cap stock picks, the hedge fund has uncovered a host of high-growth plays, each also offering an attractive valuation.

This article is written by Jake Mann and edited by Meena Krishnamsetty. Meena has a long position in SPY.

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