Billionaire Glenn Dubin’s Small Cap Picks

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The most popular small cap stocks (defined as those with market capitalization between $1 billion and $5 billion) among hedge funds outperform the S&P 500 by 18 percentage points per year on average. We think that this is because small cap stocks receive less attention from the financial media and institutional investors such as mutual funds.

Hedge funds are, therefore, more likely to uncover an undervalued or overvalued stock when they do research on these companies. As such, we think that a screen of a fund’s favorite small cap stocks can serve as a useful source of ideas for further research. Here are five of billionaire Glenn Dubin’s Highbridge Capital Management’s top small cap picks as of the end of December (or see the full list of Dubin's stock picks):

The fund owned 2.5 million shares of United Rentals (NYSE: URI), which rents construction and industrial equipment. With that line of business highly dependent on the economy, United Rentals’ stock price is very responsive to changes in broader market indices with a beta of 3.

Revenue and earnings were each up over 40% in the fourth quarter of 2012 versus a year earlier as the company’s financials continued to improve. The forward earnings multiple is 8, but we’d note that earnings will inevitably take a hit whenever the economy slows down.

Highbridge reported a position of 3.5 million shares in residential mortgage loan real estate investment trust PennyMac Mortgage Investment Trust (NYSE: PMT). Real estate investment trusts are required to distribute much of their pre-tax income to shareholders in order to maintain their favorable tax treatment. In the case of PennyMac, the result is a dividend yield of almost 9%. Of course, that high yield is partly due to the fact that the company invests in residential mortgage loans which certainly carry significant risks.

EchoStar (NASDAQ: SATS), a provider of television equipment, such as set-top boxes, is another of Dubin’s small cap picks. The stock trades at 16 times its trailing earnings, but revenue has been declining in recent quarters and Wall Street analysts are actually forecasting much lower net income for 2014. The stock has risen 38% in the last year, suggesting that the market is considerably more optimistic about EchoStar’s prospects than the sell-side. As such, we would avoid it for now.

According to the 13F, Highbridge had 2.9 million shares of SEI Investments (NASDAQ: SEIC) in its portfolio at the end of December. SEI provides wealth management and financial advisory services, and its business has been doing well. In its most recent quarterly report, revenue and net income each rose in double-digits from their levels in the fourth quarter of 2011. The stock is priced for further growth as its trailing and forward P/Es are 24 and 16, respectively. It might be worth looking into how sustainable its recent growth might be.

Dubin and his team disclosed ownership of 2.2 million shares of (NASDAQ: CTRP), which provides tour services in China. Ctrip is another stock whose price is dependent on future growth, with a trailing earnings multiple of 26. While revenue grew 29% in its most recent quarter compared to the same period in the previous year, earnings fell 24%. Bain Capital’s long/short equity hedge fund, Brookside Capital, owned 5.6 million shares according to its own 13F (check out Brookside's favorite stocks).

It looks to us that Ctrip and EchoStar need to provide more convincing results in order for us to consider them as good prospects. PennyMac is worth considering as an income stock on the basis of its dividend yield, but income investors should be sure not to invest in too many REITs and overexpose themselves to real estate prices.

SEI and United Rentals do look a bit speculative when we look at their valuation in terms of trailing earnings, but the strength of their recent results suggest they should at least be watched through their next quarterly results.

This article is written by Matt Doiron and edited by Meena Krishnamsetty. They don't own shares in any of the stocks mentioned in this article. The Motley Fool recommends International. The Motley Fool owns shares of International. 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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