Two Sigma Advisors’ Best 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.

Small-cap stocks don’t get as much attention from analysts, which often leaves them less efficiently priced than their larger peers. As can be expected, hedge funds sometimes take advantage of this by dedicating their research teams to work on the small-cap space.

In fact, retail investors can use hedge funds' top small-caps as a market-beating strategy; we’ve determined that the most popular small-cap stocks among hedge funds can earn about 120 basis points of alpha per month. We started publishing a quarterly newsletter at the end of August and since then, until the end of December, this strategy returned 14.3% vs. 2.1% for the S&P 500 index (learn more about our hedge fund small cap strategy).

Keeping this in mind, we’re going to take a look at one fund in particular: John Overdeck and David Siegel’s Two Sigma Advisors. Overdeck and Siegel have a fairly large equity portfolio (see the fund’s entire stock picks here), but let’s focus on Two Sigma’s top five small-cap holdings. As is consistent with our strategy, each stock has a market capitalization between $1 billion and $5 billion.

Two Sigma’s No. 1 small-cap stock pick is Taubman Centers (NYSE: TCO). Taubman is a retail-focused REIT, generating a 2.3% dividend yield and impressive appreciation near 30% over the past twelve months. One of Taubman’s key advantages is its ability to grow through acquisitions, and according to Morningstar, the REIT leads its peers with a tenant sales per square foot north of $680. Taubman trades at depressed sales (6.7x) and cash flow (15.2x) multiples—both around 15% lower than industry averages—so there’s clearly some value here as well.

Next up we have Ares Capital (NASDAQ: ARCC), the 17th largest holding in Two Sigma’s 13F portfolio and the fund’s second favorite small-cap. Ares Capital is a business development corporation, or BDC, that invests in a wide range of companies. Most of Ares Capital’s investments are located in the Western U.S., with more than 40% of its assets invested in 1st lien senior debt. Now, as far as BDC’s go, this percentage isn’t top-tier, but it is still solid nonetheless. Ares Capital has seen relatively stagnant earnings over the past half-decade, but the sell-side expects EPS to grow by an average of 6.8% a year through 2017. At less than 11 times forward earnings and a PEG of 1.25, this is another value play.

PDL BioPharma (NASDAQ: PDLI) is Two Sigma’s third largest small-cap holding and has seen its shares lose over 6% in the past week. PDL BioPharma was downgraded by Credit Suisse to “underperform” on Tuesday, but at a lowly PEG of 0.37 there still looks to be some value in the stock. Wall Street expects PDL’s earnings to more than double this year, and according to Zacks, royalties from the trio of Biogen, Roche and Elan give reason to be bullish. Additionally, PDL pays a very strong dividend yield above 8%, so there’s something here for both value and income-oriented investors.

In fourth place we have Penn National Gaming (NASDAQ: PENN), which is expected to create the first ever casino-based REIT this year. Penn has been up close to 20% over the last three months as investors are optimistic on the revolutionary property spin off, and it still trade below 18 times forward earnings. The sell-side predicts that earnings will grow by 21-22% over the next year. With the strong possibility that investors will receive shares of Penn’s REIT on a one-to-one basis in addition to a special dividend, there’s a lot to like about this stock at the moment.

Last but certainly not least, American Capital (NASDAQ: ACAS) is Two Sigma’s fifth favorite small-cap stock pick. Like Ares Capital, American Capital is a BDC and has its fingers in everything from cable set-top boxes to sporting goods. American Capital has seen its earnings shrink by an average of 11% a year over the past half-decade, but analysts expect this growth to be positive (15% annually) over the next five years. With this in mind, shares of the BDC trade at a measly PEG ratio of 0.19, indicating that investors aren’t accounting for this growth.

For more related coverage, check out the hedge fund industry’s interest in American Capital on Insider Monkey

This article is written by Jake Mann and edited by Meena Krishnamsetty. They don't own shares in any of the stocks mentioned in this article. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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