The Small-Cap King’s Five 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.

In the financial universe, large-caps receive the most focus from investors, which often leaves their smaller peers less efficiently priced. Expectedly, hedge funds seek to take advantage of this phenomenon by dedicating their research teams to work on the market’s lesser-known companies.

Interestingly, our analysis at Insider Monkey shows that the most popular small-cap stocks among hedge funds can earn about 120 basis points of alpha per month. Best yet, retail investors can use hedge funds' top small-caps as a market-beating strategy; 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).

With this in mind, we’re going to focus on the so-called ‘Small-Cap King,’ Chuck Royce and his fund, Royce & Associates. Royce has an enormous equity portfolio in excess of $31 billion (see the mammoth fund’s entire profile), but let’s just concentrate on his top five small-cap holdings. Each stock listed here had a market capitalization between $1 billion and $5 billion at the end of the third quarter, which is the same standard used in our premium strategy.

First up we have Westlake Chemical Corporation (NYSE: WLK), which was Royce’s No. 1 overall holding at the end of the last 13F filing period with the SEC. The chemical company, which focuses on olefin and vinyl compounds, has seen its shares skyrocket over the past 12 months, up close to 55%. Low NGL (natural gas liquids) prices—particularly ethane—have been a boon to Westake’s profitability.

Gross margins are at their highest level (17.2%) since 2005, and the company has beaten Wall Street’s earnings estimates in three consecutive quarters. Westlake’s bottom line currently trades at a 12% discount to the specialty chemicals industry’s average, so it appears there’s still some upside to be had. A moderate dividend projected to yield close to 0.9% is also a nice benefit for income-seeking investors as well.

The Buckle (NYSE: BKE), meanwhile, is Royce’s second largest small-cap investment. Shares of the apparel retailer hit an all-time high above $51 a share late last year, and its latest financials (Q3 FY2013) represented a solid beat on the top and bottom lines. Management cited private label growth—with men’s denim highlighted—as key reasons behind the company’s prosperity. The sell-side expects slowing EPS growth over the next five years, averaging about 8.5% annually, but Buckle’s stock price still trades at a cheap 13.4 times forward earnings. Moreover, a dividend yield of 1.7% gives an additional cushion, so to speak.

Teradyne (NYSE: TER), the automatic test equipment company, is Royce’s third favorite small-cap. Teradyne has generated quarterly EPS beats in three consecutive quarters, with the latest coming in its fiscal fourth quarter last week. Since reporting a 7 cent EPS that was 6 cents above analysts’ consensus, shares have actually fallen more than 4%. It’s unclear why this slight sell-off has occurred, but it may simply be related to profit taking, as Wall Street’s average price target on Teradyne still forecasts a 22-23% upside is in the cards. Of the 16 analysts who cover this stock, 11 hold buy ratings and none are bearish, and at a mere 9 times forward earnings, it’s hard to disagree with Royce here.

Lincoln Electric Holdings (NASDAQ: LECO) is the hedge fund manager’s fourth largest small-cap holding, and is a stock that’s already up more than 9% since the start of the New Year. Lincoln Electric is primarily focused on arc welding products, and the 100+ year old company is also exciting investors in the automated welding space. The company has seen its earnings grow by an average of nearly 5% a year over the past half-decade, but the Street expects this growth to double over the next five years.

Strong positioning in a continually consolidating industry is a key reason behind analysts’ bullishness, and a projected dividend yield of 1.5% isn’t too shabby either. Shares of Lincoln Electric do trade at industry-average valuation metrics no matter how you slice it, but a market leader with accelerating growth makes the stock a good addition to most investors’ portfolios.

Last but certainly not least, we have Reliance Steel & Aluminum (NYSE: RS), Royce’s fifth largest small-cap stock pick. Reliance has provided investors with a return (16.2%) nearly thrice that of the metal fabrication industry’s average over the past 12 months, and has also performed quite impressively over the shorter term. The company has beaten the sell-side’s earnings consensus in each of the past five quarters, despite a less than stellar economic environment for steel-related companies.

In comparison to its peers, Reliance’s main advantage lies in its commitment to consistent dividend payouts, willingness to engage in M&A expansion  (particularly in oil and gas) and its below-average cost structure. At a mere 11 times forward earnings and 0.5 times sales, Reliance offers investors a great way to play a steel rebound, which likely explains Royce’s bullishness. Joining the hedge fund manager in this company are Cliff Asness and David Dreman, among others (see David Dreman’s favorite stock picks).


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 recommends The Buckle. The Motley Fool owns shares of The Buckle. 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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