Hedge funds are selling these stocks: Should you?

Looking for a contrarian play? Consider these names that show signs of institutional selling.

By MoneyShow.com May 21, 2013 12:31PM

Arrow Down © ImageSource PictureQuestBy the staff at Kapitall.com

Fund managers always buy and sell stocks. But sometime, despite many of them having the same bearish sentiment on a stock, there's no apparent reason for the sentiment. So, within the industrial category, we looked for stocks that might not merit such a lack of confidence from fund managers. 

We further searched for data that suggest a more positive future, including evidence of undervaluation and positive returns on investment and assets.

Building the list 
We screened industrial goods stocks for bearish sentiment from institutional investors, with significant net institutional sales over the last quarter representing at least 5% of share float (MoneyShow.com). This indicates that institutional investors such as hedge fund and mutual fund managers expect these companies to underperform.

Next, we screened for criteria that might contradict the institutional investors' opinions of the stocks. We searched for companies that appear undervalued relative to their cash flows, indicated by high ratios of levered free cash flow-to-enterprise value (LCFC/EV).

Levered free cash flow is the free cash flow after deducting interest payments on outstanding debt. Enterprise value is the sum of the firm's value from all ownership sources: market cap, outstanding debt, and preferred shares. When companies have ratios of levered free cash flow-to-enterprise value in excess of 10%, it may indicate that the company as a whole is being undervalued.

The list 
This left us with two companies, operating in aerospace and defense products and services, general building materials and industrial electrical equipment. To further compare these stocks, and to better understand why hedge funds might not consider them worthwhile investments, we also looked at their respective returns on assets (ROA), equity (ROE) and investments (ROI).

ROA is the result of dividing a company's annual earnings by its total assets, and it shows how adept management is at using its assets to generate earnings. ROE is a measure of profitability showing the total net income returned as a percentage of shareholder equity. The ROI is a popular measure of profitability, calculated by dividing net profits by total assets. We compare these to the aerospace and defense products and services industry average.

Click to Enlarge

Do you agree with institutional investors that these companies aren't worth the risk? Or do you feel they are undervalued and can deliver exceptional returns in the future? Use this list as a starting point for your own analysis.

1. Smith & Wesson Holding Corporation (SWHC) offers metal processing services and manufactures firearms and handcuffs as well as apparel and sportsmen's articles.

  • Market cap at $568.46 million, most recent closing price at $8.86.

  • Net institutional sales in the current quarter at -9.7 million shares, which represents about 15.45% of the company's float of 62.78 million shares.

  • Levered free cash flow at $55.98M vs. enterprise value at $548.60M (implies a LFCF/EV ratio at 10.2%).

  • Earnings per share growth this year: 215.21%

  • ROA: 27.19% (vs. industry average 7.17%)

  • ROE: 55.24% (vs. industry average 25.39%)

  • ROI: 36.95% (vs. industry average 9.58%)

  • 52 week high: -21.42%

Hedge funds were onto something: SWHC has returned -1.99% since April 12, 2013, and is one of the worst performing stocks in its industry. The stock is falling behind companies such as General Dynamics (GD) and Boeing (BA), which returned 7.22% and 6.56%, respectively, during the same time period. [Boeing competes in the production of weapons.]

Short sellers think there's more downside to the stock, especially when comparing short float to industry averages (MoneyShow.com). SWHC short float stands at 21.85%, which is equivalent to 5.66 days of average trading volume. As an example, this is much higher than United Technologies (UTX) (short float at 0.86%, representing 2.37 days of trading volume) and BA (short float at 1.10%, representing 1.7 days of trading volume).

However, the company has reported strong earnings growth over the last year, with earnings per share (EPS) growing by 215.21%, significantly higher than competitors like Lockheed Martin (LMT) (EPS growth over the last year at 6.56%) and BA (EPS growth over the last year at -4.07%).

And SWHC has a higher than average projected earnings growth rate over the next five years (30.0%). This is stronger again than the likes of LMT (projected EPS growth over next five years at 6.72%), GD (projected EPS growth over next 5 years at 6.35%) as well as Sturm, Ruger & Co. (RGR) (projected EPS growth over next 5 years at 0.0%).

On May 7, Smith & Wesson was downgraded by Zacks analysts from an outperform rating to a neutral rating. Zacks currently has $11.20 price target on the stock, which is still a 26.8% upside from current levels.

2. US Concrete Inc. (USCR) engages in the production and sale of ready-mixed concrete, precast concrete products, and concrete-related products for use in commercial, residential, and public works construction projects in the United States.

  • Market cap at $201.57 million, most recent closing price at $15.11.

  • Net institutional sales in the current quarter at -452,800 shares, which represents about 5.7% of the company's float of 7.95 million shares.

  • Levered free cash flow at $42.41 million vs. enterprise value at $252.24 million (implies a LFCF/EV ratio at 16.81%).

  • EPS growth this year: -219.69%

  • ROA: -4.86% (vs. industry average 7.17%)

  • ROE: -12.35% (vs. industry average 25.39%)

  • ROI:-7.33% (vs. industry average 9.58%)

  • 52 week high: -7.53%

The company's earnings growth looks weak, with EPS growing by an incredibly low -219.69% over the last year. This is considerably weaker than competitors like MAS (EPS growth over the last year at 83.38%) and VMC (EPS growth over the last year at 28.54%).

USCR has performed in line with the rest of its industry since April 12, 2013, returning 7.54% over the last month. This performance has been better than Masco (MAS) and Fastenal (FAST), but worse than industry leaders like Vulcan Materials (VMC) and Martin Marietta Materials (MLM), which returned 11.64% and 8.76% respectively.

USCR has a low short float compared to industry averages, suggesting perhaps that short sellers see limited downside in the stock. The company's short float stands at 0.43%, much lower than MLM (short float at 11.17%, representing 12.72 days of trading volume) and FAST (short float at 6.12%, representing 10.98 days of trading volume).

In mid-March the stock was upgraded from a sell rating to a hold rating by analysts at Zacks and TheStreet. Mirroring the information above, TheStreet analysts cited "revenue growth, solid stock price performance and good cash flow from operations" as a reason for the upgrade. They also expressed concern in USCR's "deteriorating net income, disappointing return on equity, and poor profit margins."



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