Value Investor Joel Greenblatt’s Small Cap Picks

Meena is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Joel Greenblatt, the former manager of Gotham Capital, has achieved a widespread following among investors through his books (including You Can Be A Stock Market Genius) and his “Magic Formula” among other activities (normally this degree of self-promotion worries us, but Greenblatt does actually offer useful lessons).

We track Greenblatt’s 13F filings alongside those of hundreds of hedge funds and other notable investors as part of our work developing investment strategies; we have found, for example, that the most popular small cap stocks outperform the S&P 500 by an average of 18 percentage points per year. We attribute this result to large institutional investors such as mutual funds paying less attention to small cap stocks. If small cap stocks are often mispriced, we can scan individual 13Fs for which small caps top managers like so that investors can do further research on any interesting names. Here are Greenblatt’s five largest small cap holdings as of the end of March (or see the full list of his stock picks):

Warner Chilcott (NASDAQ: WCRX), a $4.9 billion market cap pharmaceutical company, was Greenblatt’s top pick with the filing disclosing ownership of 1.4 million shares. The stock’s trailing earnings multiple of 12 makes it an arguable value play, though in the first quarter of 2013, the company recorded a 13% decline in revenue versus a year earlier. Wall Street analysts expect Warner Chilcott to recover -- in fact, their consensus forecasts for 2014 show growth in earnings per share, and imply a forward P/E of only 6 -- but of course, analysts might often be too optimistic.

Greenblatt slightly increased his stake in GameStop (NYSE: GME) to a total of about 660,000 shares. GameStop has more than doubled in price over the last year, even as business has struggled: in its most recent quarter, revenue slipped 7% compared to the same period in the previous fiscal year, with earnings falling by over 20%. The most recent data shows that 36% of the float is held short. Cliff Asness’ AQR Capital Management owned almost 4 million shares of GameStop at the beginning of April (find Asness' favorite stocks).

According to the 13F, Greenblatt had close to 300,000 shares of $3.3 billion market cap biotech company United Therapeutics (NASDAQ: UTHR) in his portfolio at the end of the first quarter of this year. United Therapeutics is another popular short target, with 17% of the float held by short sellers, despite the fact that its trailing and forward P/Es are 12 and 9, respectively. The sell-side predicts decent earnings growth over the next several years and as a result, the stock’s five-year PEG ratio is well below 1.

While the value investor cut his stake in mattress company Tempur Sealy International (NYSE: TPX), which was known as Tempur-Pedic prior to its acquisition of Sealy, by 22%, the filing still showed a position of about 340,000 shares. Even with earnings down sharply, the stock has come close to doubling in the last year as investors look for this consolidation to help the company. Analyst optimism has given the stock a valuation of 14 times forward earnings estimates, but we’d be a bit worried about potential integration risk and would avoid the stock for now.

Security and intelligence services provider SAIC (NYSE: SAI) rounds out our list of Greenblatt’s small cap picks. The company serves a number of government agencies, including the Department of Defense and Department of Homeland Security, among others. Analysts are predicting lower earnings per share next year than what the company has done on a trailing basis -- possibly due to federal spending cuts -- and in fact, both revenue and earnings were down last quarter compared to the first quarter of 2012. SAIC trades at 9 times trailing earnings, so the market is not looking for much growth here either.

We agree that SAIC’s business is uncertain going forward, and with recent results being weak, we are skeptical of it as a potential value despite the low multiples -- other contractors might be better options for investors who think the risks of spending cuts are overplayed. We also don’t like Tempur Sealy very much, as we’ve mentioned. In the case of GameStop, we are very wary about how the company would be affected by how next-gen consoles from Microsoft and Sony will affect a brick-and-mortar retail game business (with digital distribution having already negatively impacted its PC game sales) and would avoid that stock as well.

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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 owns shares of GameStop and Tempur-Pedic 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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