Billionaire David Einhorn’s Small-Cap Picks

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Billionaire David Einhorn of Greenlight Capital is one of the most closely followed hedge fund managers in the world. We track quarterly 13F filings from Greenlight and hundreds of other hedge funds as part of our work researching investment strategies. One of our findings so far has been that the most popular small-cap stocks among hedge funds earn an average excess return of 18 percentage points per year, and our live testing of this strategy has returned 38% since September 2012. If hedge funds’ small-cap picks are likely to do well, it’s at least possible to use individual managers’ top picks in this category as sources of initial investment ideas, performing further research on other interesting names. Read on for our thoughts on Greenlight’s five largest small-cap holdings by market value as of the end of March and see a history of Greenlight's stock picks.

The fund maintained a position of 4.9 million shares in Aspen Insurance Holdings (NYSE: AHL), an insurance and reinsurance company. Aspen’s quantitative metrics indicate that it is in fact a potential value stock: it trades at a significant discount to the book value of its equity, with a P/B ratio of 0.7, and its earnings multiples are in the 10-11 range. Revenue and earnings have also been up, and Aspen looks like it is worthy of further research. Of course, peers in the industry may carry similar numbers.

Einhorn and his team reported owning 2.2 million shares of financial services and customer service software company DST Systems (NYSE: DST) at the end of March. DST recently experienced a temporary boost in earnings unrelated to its core business, though during Q1 its revenue and operating income were both up moderately versus a year earlier. The stock currently trades at 14 times forward earnings estimates, so while it does need some earnings growth going forward to justify its current valuation expectations are not too high in terms of recent performance. As such it might be a prospective value play as well.

Babcock & Wilcox (NYSE: BWC) was another of Greenlight’s small cap picks with the filing disclosing ownership of 4.1 million shares. The company provides components to power plants and also supplies nuclear reactors to the U.S. Navy for use in ship construction. Wall Street analysts apparently believe that Babcock & Wilcox is immune from any potential declines in military spending, as their forecasts for earnings per share over the next several years imply a forward P/E of 12 and a five-year PEG ratio of 0.7. We wouldn’t place too much trust in these forecasts, however.

According to the 13F, Einhorn cut his stake in asset manager Legg Mason (NYSE: LM) by 25% but still owned 2.5 million shares at the end of the first quarter of this year. Legg Mason is priced at a discount to book value, but a small one, and in its most recent quarter net income was down considerably compared to the same period in the previous fiscal year. The stock is cheap enough that it’s probably not a good short - even though shorts are responsible for 10% of the float - but Legg Mason also doesn’t look like a good buy right now. Billionaire Nelson Peltz’s Trian Partners owned nearly 13 million shares of the stock (find Peltz's favorite stocks).

Greenlight disclosed ownership of 1.2 million shares of $3.2 billion market cap infrastructure technical and management services company AECOM (NYSE: ACM) in the filing. Last quarter, AECOM’s earnings were up 10% compared to a year ago, but revenue was down slightly. Still, even after a nearly 90% rise in the stock price over the last year, AECOM is currently valued at 11 times consensus earnings for the fiscal year ending in September 2014. As such, it too is a potential value stock, although we would be concerned about the lower sales.

We’d say that a number of these small-cap picks look like they could indeed be cheap. Legg Mason is something of an exception, at least for now, with its business doing poorly recently. The rest of Einhorn’s picks discussed here, however, are generally priced low in terms of either the book value of their equity or earnings numbers. Investors may want to take a closer look at them.

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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 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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