Hedge Funds Are Selling These Stocks—Should You?

05/21/2013 7:00 am EST


Looking for a contrarian play? To create the list below, the staff at Kapitall.com screened stocks in the industrial goods sector for signs of institutional selling.

Within the industrial category, we looked for stocks that might not merit such a lack of confidence from fund managers, and 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 sentiments from institutional investors, with significant net institutional sales over the last quarter representing at least 5% of share float. This indicates that institutional investors such as hedge fund managers 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/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/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/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, equity and investments.

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 return on investment (ROI) is a popular measure of profitability, calculated by dividing net profits by total assets. We compare these to the aerospace/defense products and services industry average.

Analyst ratings sourced from Zacks Investment Research.

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 $568.46M, most recent closing price at $8.86.

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

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

  • EPS 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 4/12/13, and is one of the worst performing stocks in its industry. The stock is falling behind companies like General Dynamics Corp. (GD) and Boeing Co. (BA), which returned 7.22% and 6.56%, respectively, during the same time period. [Boeing competes in the production of weapons.]

NEXT PAGE: Another Stock with Bearish Sentiment


Short sellers think there's more downside to the stock, especially when comparing short float to industry averages. 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 Corp. (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 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 5 years at 6.72%), GD (projected EPS growth over next 5 years at 6.35%) as well as Sturm, Ruger & Co. Inc. (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 $201.57M, most recent closing price at $15.11.

  • Net institutional sales in the current quarter at -452.8K shares, which represents about 5.7% of the company's float of 7.95M shares.

  • Levered free cash flow at $42.41M vs. enterprise value at $252.24M (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 4/12/13, returning 7.54% over the last month. This performance has been better than Masco Corporation (MAS) and Fastenal Company (FAST), but worse than industry leaders like Vulcan Materials Company (VMC) and Martin Marietta Materials Inc. (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."

*Accounting data sourced from Google Finance, institutional data sourced from Fidelity, EPS and LFCF data sourced from Yahoo! Finance, all other data sourced from Finviz.

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