A Auto Car: Hedge Funds Love These 5 Stocks -- but Should You?

Hedge Funds Love These 5 Stocks -- but Should You?

BALTIMORE (Stockpickr) -- Looking to pare down your stock portfolio as the market drops? Not so fast.

Must Read: 10 Stocks George Soros Is Buying

At the same time that retail investors have been selling stocks out of concerns of a top, hedge funds have been buying them -- albeit a little more selectively than in the last few years. What's interesting is that the sectors funds were piling into in the third quarter are the same sectors that got hit the hardest in the third quarter: energy and materials. While others, such as health care, have been relative strength champs in recent months.

(Hedge funds are also taking gains on the high-performing financial sector right now.)

Put simply, funds are ramping up exposure to what's working, but they're also willing to grab onto sectors that could be starting to get oversold. Most important, the position sizes that funds took in the third quarter were much smaller than their bets in previous periods of 2014. That implies that the few names the "smart money" is picking up at this stage are the high-conviction bets.

So which names are pro investors piling into? And which still make sense to buy now? Today we'll answer both of those questions by peeking at the latest round of 13F filings.

Institutional investors with more than $100 million in assets are required to file a 13F, a form that breaks down their stock positions for public consumption. From hedge funds to mutual funds to insurance companies, any professional investors who manage more than that $100 million watermark are required to file a 13F.

In total, approximately 3,800 firms file 13F forms each quarter, and by comparing one quarter's filing with another, we can see how fund managers are moving their portfolios around. While the data is generally delayed by about a quarter, that's not necessarily a bad thing. Research shows that applying a lag to institutional holdings can generate positive alpha in some cases. That's all the more reason to crack open the moves being made with pro investors' $20.5 trillion under management.

And since it's still very early in 13F season, we're able to use a small sampling of early filers to get a sneak peek at what funds are doing before the rest of the forms hit the SEC's servers.

Today, we'll focus on hedge funds' 5 favorite stocks.

Must Read: Warren Buffett's Top 10 Dividend Stocks

Range Resources

Up first is large-cap oil and gas exploration stock Range Resources (RRC). Like the rest of the energy sector, Range has been getting shellacked in recent months, selling off more than 25% since the calendar flipped to January of this year.

But fund managers are getting confident as Range slips lower; early-filing funds picked up 7.91 million shares of the E&P, bringing their total position to $636 million. Range Resources is the definition of a conviction bet. These funds quintupled their holdings in this stock during the third quarter of 2014.

As an independent exploration and production firm, Range's job is to pull energy commodities out of the ground. The firm's energy projects are based in the U.S., with 2 million acres in stakes across the Marcellus Shale, Mid-Continent and Permian Basin. The firm's 8.2 trillion cubic feet of gas equivalent in proved reserves is skewed heavily towards natural gas (approximately 70%). Given the multiyear bear in nat gas, and comparatively high price of crude, investors have been hungry for low-cost nat gas producers who can benefit disproportionately from higher prices in gas.

Range owns some of the most attractive positioning in North America, with productive properties in some of the most sought-after regions of the continent. The firm also hasn't been shy about selling off assets for the right price. Given RRC's deep portfolio of reserves, the possibility of new asset sales could unlock value quickly.

In my view, the energy sector has further to fall -- potentially a lot further. But once commodity prices show signs of a bottom, RRC becomes a bargain-priced way to play a rebound. With that in mind, I think funds are early on this trade. Don't make the same mistake.

Must Read: 7 Stocks Warren Buffett Is Selling in 2014

Eli Lilly

Pharma giant Eli Lilly (LLY), on the other hand, has been having a solid year in 2014, with s hares up almost 24% so far. The health care sector has been one of the few shining stars in the last few months, and pharmaceutical names such as Lilly provide an easy way to ride the trend and capture a fat dividend yield at the same time (LLY pays out 3.1% at current levels). And funds put shares of this drug maker near the top of their buy list in the third quarter as a result. During the quarter, funds picked up 761,010 shares of the firm, a $48 million bet at current price levels.

Historically, Eli Lilly has been one of a small group of high-performing drug names. The firm's pharmaceuticals include well-known names such as depression and fibromyalgia treatment Cymbalta, diabetes drug Humulin and erectile disfunction treatment Cialis. Like many of its peers, Lilly has a big set of black clouds in the firm of a patent cliff. As the firm's branded drugs get closer to expiration, Lilly is under pressure to get more of its pipeline closer to commercialization to fill that gap. That said, recent patent losses have proven "less bad" than Wall Street expected, and new indications for existing drugs is helping Lilly extend its shelf life. As a new wave of drugs comes off of trials and into the market, the firm should be able to regain any interim shortfall in revenues.

Financially, LLY is in good shape. The firm's $11.78 billion in cash and investments easily offsets a $5.3 billion debt load, providing enough net cash to cover nearly 10% of the firm's market capitalization today. That's a big risk reducer for investors concerned about the stability of Lilly's dividend here.

At current levels, Lilly isn't cheap, but it's not particularly expensive either -- and its big payout and health care sector exposure should help keep it an outperformer this year.

Must Read: 10 Stocks Carl Icahn Loves in 2014

iShares Core U.S. Aggregate Bond Fund

Interestingly enough, one of the biggest conviction stock bets from hedge funds last quarter wasn't a stock at all but an exchange-traded fund. I'm talking about the iShares Core U.S. Aggregate Bond Fund (AGG). Hedge funds picked up more than 3.6 million shares of the fund last quarter, more than doubling their exposure to this large ETF. And I think that remains a good move today.

Why the ETF?

Put simply, you won't find a better (or cheaper) way to get exposure to U.S. investment-grade fixed income than with AGG. This fund owns bonds (primarily long-term), more than two thirds of which are backed by the U.S. government. That exposure gives AGG minimal exposure to the risk of default, and instead makes it more of a play on interest rates. The real beauty of AGG is that it provides that bond exposure with a tiny 0.08% expense ratio and an extremely liquid trading vehicle.

Even though most investors are still counting on a rate hike in the near-term, this environment just doesn't support it. Instead, the rate hike commentary looks more like an attempt at a self-fulfilling prophecy by the Fed. The possibility of lower interest rates six months from now seems insane today on its face, but if recent history is any indication it's actually quite likely. AGG is one of the best ways to play it.

Must Read: 10 Stocks Billionaire John Paulson Loves in 2014

Mosaic

Fertilizer company Mosaic (MOS) is another commodity-linked stock that hedge funds piled into in the third quarter. All told, early-filing funds added 9.69 million shares of the $15.5 billion name to their portfolios during the period, more than doubling their ownership of this ag stock.

Mosaic is the world's largest producer of phosphate and potash fertilizers. The firm is vertically integrated, involved in everything from mining to production to wholesale distribution. Size is a big advantage in the asset-intense fertilizer business, and MOS' huge scale means that it's able to have a meaningful impact on industry-wide supply (and thus prices). But while that mitigates the problems at Mosaic right now, it doesn't solve them.

Soft commodity prices have been falling hard alongside energy prices in recent months, slammed by a rallying dollar and tentative central bank efforts overseas. And as farmers get closer to their cost of production right here, the incentives shift away from growing more until prices react to that supply shortage. In the intermediate term, that could spell revenue shortfalls at MOS, particularly as farmers wrap up growing season this fall and start thinking about their fertilizer needs for next year.

I'd suggest avoiding Mosaic here.

Must Read: 12 Stocks Warren Buffett Loves in 2014

Microsoft

Last up on funds buy list is Microsoft (MSFT). This $360 billion software giant has evolved into one of the staid blue chip names of the technology sector, so it's no surprise that it was one of the few tech stocks that hedge funds picked up (as a sector, funds actually cut their net exposure to tech in the third quarter). Year-to-date, MSFT has seen a slow and consistent climb higher, in contrast to the more active momentum names that have seen boom and bust cycles in 2014 -- but even though Microsoft hasn't been as drama-filled, its business is still undergoing big changes.

In recent years, Microsoft has worked hard to boost its exposure to "side businesses" like mobile phones, tablets, and gaming systems. Even though those efforts have been pretty hit-or-miss, Microsoft can afford to experiment in that space. That's because the firm's bread and butter is still the Windows operating system and Office suite of productivity tools. Commercial sales make up nearly 60% of all revenues as of this past year, and those enterprise sales have been strengthening, even as competition remains a challenge on the consumer side of the business. That sales cushion from Microsoft's Windows and Office franchises is an important luxury for management in 2014.

Financially speaking, cash is another important luxury. Microsoft currently carries more than $100 billion in cash and investments on its balance sheet, versus a $22 billion debt load. That balance sheet position covers more than 21% of Microsoft's current market capitalization today, and gives the firm an ex-cash P/E ratio of just 13. That's a bargain-priced valuation, even if Microsoft isn't the most exciting stock in the sector.

Last quarter, funds added 527,530 shares of Microsoft to their portfolios. That looks like a bet that should outperform the S&P in the fourth quarter.

Must Read: Warren Buffett's Top 10 Dividend Stocks

To see these stocks in action, check out the Institutional Buys portfolio on Stockpickr.  

-- Written by Jonas Elmerraji in Baltimore.

A Auto Car

Thursday, October 16, 2014

Hedge Funds Love These 5 Stocks -- but Should You?

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