Home Hedge Funds Three Small Caps That Hedge Funds Just Added to Their Portfolios

Three Small Caps That Hedge Funds Just Added to Their Portfolios

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Small-cap stocks have seen a resurgence in the past several months, as the Russell 2000 topped the large-cap S&P 500 in the fourth quarter, returning 13.6%. Through the first three quarters of the year, the Russell 2000 had a negative return, so the fourth quarter rally was welcomed by investors – and long overdue.

Some Wall Street strategists expect the small-cap rally to continue in 2024, as the market is attractively valued in an improving economic environment. “With a cheaper starting valuation and the expectation of rates coming down, we believe small caps will have their moment in the sun this year,” wrote Dominick D’Angelo, research analyst at O’Keefe Stevens Advisory, in the fourth quarter letter to investors. The firm sees the Russell 2000 as the top performing index in 2024.

In the fourth quarter, hedge fund managers were mining the small-cap universe for good deals, which is not easy when such a large chunk of the companies are not profitable. But here are three stocks that hedge fund managers recently added to their portfolios that investors might not have heard of but should get to know.

1 – Duckhorn Portfolio

Duckhorn Portfolio (NYSE: NAPA) is not a household name, unless you are a wine enthusiast, then you might know this luxury wine brand based in Napa Valley, Calif. The small-cap stock, with a market capitalization of $1 billion, is trading at just under $9 per share and has a consensus buy rating and a $13 per share price target among analysts.

Merion Road Capital Management, a Miami-based hedge fund manager, added Duckhorn Portfolio in December to its small cap fund. Merion Road Capital Founder and Chief Investment Officer Aaron Sallen, in his fourth quarter letter to investors, sees some upside from a recent acquisition. Last year, Duckhorn acquired Sonoma-Cutrer Vineyards, a luxury Chardonnay winery, from Brown-FormanBF.B, one of the largest wine and spirits companies in the country.

“Sonoma-Cutrer is a great fit for NAPA as it fills out a portion of their portfolio that was previously underserved, maintains extremely strong brands, aligns with their luxury footprint, and provides significant production resources,” wrote Sallen. The $400 million stock and cash deal gives Brown-Forman a 21% equity stake in Duckhorn and two board seats. Sallen sees this as a good thing for Duckhorn.

“Perhaps the best run spirits company is taking a large financial and governing position in what is relatively a small company. While it is unfortunate that the company does not have a full-time CEO, they benefit from a proven interim operator in Dierdre Mahlan who formerly ran Diageo North America,” Sallen wrote.

He believes Duckhorn’s earnings are poised to accelerate, particularly after they name a new CEO and integrate Sonoma-Cutrer.

2 – American VanguardAVD

This is not the investment giant; rather, American Vanguard (NYSE: AVD) is a manufacturer of crop and plant protection chemicals. It has a market cap of about $310 million and is trading at around $11 per share, with a price target of $15.50 among the couple of analysts that cover it.

The stock had a brutal year, down about 49% in 2023, but the devaluation of the stock created a buying opportunity for hedge fund managers like Cove Street Capital, which added it to its small cap value fund last quarter.

“We have bought and sold AVD at various points throughout the last decade, but this iteration presents a unique confluence of factors we view as highly favorable,” wrote Jeffrey Bronchick, portfolio manager of the Cove Street Capital Small Cap Value Fund, in the fourth quarter letter to investors.

American Vanguard suffered last year from a drop in sales as the distributors that they sell to reset their inventory levels lower due to higher interest rates, among other factors. Also, wrote Bronchick, two of American Vanguard’s top products were temporarily off the market during the 2023 growing season because of various regulatory and supply chain issues. This resulted in a $50 million to $60 million revenue hit.

Since then, the company went through a transformation plan to improve operations and capital management, bringing in new board members and operations staff to execute on it.

“We expect much of this lost revenue to return simply by basic execution as well as a meaningful working capital swing following the bottom of this inventory destocking that should free up cash flow and allow AVD to reduce debt,” Bronchick wrote in the letter. He and his team see “meaningful upside” if the business returns to its historically steady earnings margins.

3 – Birkenstock Holding

The world-renowned sandal maker from Germany, Birkenstock (NYSE: BIRK), has been around since 1774, but it just went public and started trading on the New York Stock Exchange last quarter. Baron Funds added to its Baron Asset Fund portfolio, buying more than 17 million shares in the stock last quarter. Long run by the Birkenstock family, it was acquired by private equity firm L Catterton about 10 years ago and was brought public last year. Baron Asset Fund portfolio manager Andrew Peck wrote in a Q4 letter to shareholders that the company has grown revenue at a compound annual growth rate of 20% from 2014 through 2022.

“We believe this combination of an iconic brand with high growth and industry-leading profitability makes the Birkenstock brand an attractive asset,” Peck wrote in the letter.

Among its advantages is its brand, bolstered by a guest starring role in the blockbuster Barbie movie. But also, as Peck stated, the company makes all of its products in-house, mostly in Germany, which provides it with “better quality control and less risk in its supply chain.” Peck expects to see Birkenstock, with only 45 stores, expand its footprint, and sales, significantly, particularly in untapped markets like Asia.

“Over the medium term, we believe Birkenstock will be able to increase revenue by 15% per year or more, driven by ongoing growth in its core styles, expanded year-round product mix, new stores, and geographic expansion,” Peck wrote in the letter.

As always, investors should do their own research before buying any stock, but these selections from the experts may provide a head start.

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