Legg Mason’s Top-Performing Small Caps

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Small-cap and mid-cap stocks do not get as much coverage from bankers and third-party analysts, often leaving them less efficiently priced versus larger stocks. Hedge funds sometimes take advantage of this by dedicating their research teams to work on these lower-valuation stocks, and they often earn substantial alpha from their investments. Based upon our analysis of many hedge funds’ small-cap holdings, 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 shared the stock picks of this strategy. Since then, this method has returned 23.9% vs. 7.4% for the S&P 500 (learn more about our hedge fund small cap strategy here). Along that same vein, here are five stocks Bill Miller of Legg Mason Capital Management owns as of his recent 13F filing that had market caps between $1 billion and $5 billion and provided huge returns for 2012.

Bill Miller’s best-performing stock in our small cap range was Exterran Holdings (NYSE: EXH). They offer solutions for producing, processing, and transporting oil and gas, primarily in the field of natural gas compression. The stock more than doubled from a year prior, rewarding investors with a 119% gain. As with many of the smaller oil & gas plays, speculation is rampant and can cause such rises without traditional fundamental support. Analysts are a bit burnt out with EXH’s rise and advise a hold from here on out. Billionaire Ken Griffin of Citadel Investment Group has a debt investment in EXH to the tune of $28 million; see his other bond holding here.

Real estate investment company Newcastle Investment (NYSE: NCT) saw an 85% increase in share price, partly due to the increase in real estate valuations as the residential and commercial markets continue to recover. UBS hopped on the Buy bandwagon in December of 2012, joining Credit Suisse and Barclays as bulls regarding NCT. Not to be ignored, Newcastle’s excellent dividend yield of 8.3% provides investors another reason to jump in. Malcolm Fairbairn of Ascend Capital has done just that, with almost 3 million shares. 

Payment transaction experts FleetCor Technologies (NYSE: FLT) was another big winner for Legg Mason, beating the S&P 500 by more than fifty percentage points, helping the stock reach new 52-week highs at its current levels. Hound Partners initiated an almost $100 million position as indicated by their last 13F filing. Sell-side analysts see the rise as “too much, too quick,” and are expecting the price to drop by a few percentage points to be more in line with valuations. FLT reports earnings on Feb. 7, so potential investors should be wary as the announcement is right around the corner.

Continue reading to see Miller’s other hot small cap plays.

CoStar Group (NASDAQ: CSGP) was another real estate-related play, although they are not an investment firm. They provide analytic services to the commercial real estate industry both in the States and across the pond in the UK. The stock surprised analysts every quarter, with the earnings beats pushing the stock to a 65% gain on the year. While price to earnings valuations remain chaotic, CSGP’s positive earnings and revenue growth year-over-year provided a lot of reason to the boost. Billionaire Jim Simons of Renaissance saw CSGP fit to be added to his portfolio.

Redwood Trust (NYSE: RWT) rounds out our list of Legg Mason’s top small-cap performers, and it is a very little surprise that it is another real estate investment trust. The empirical growth of small-caps combined with the stronger real estate market has easily given this list a slant, and for good reason. While not a 100% increase in stock value like EXH, Redwood’s returns were in excess of 50%, considerably beating the S&P’s paltry 12.6% gain. We join analysts on the Street as being bullish on RWT, noting their conservative P/E and favorable dividend payout structure. Wallace Weitz has made this one of his top five picks.

This article is written by Eric Winter 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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