The 10 Best Stock Picks of the 10 Richest Hedge Funds

10 Best Stock Picks of the 10 Richest Hedge Funds
10 Best Stock Picks of the 10 Richest Hedge Funds

Ever wish you could make $4 billion a year? That wish came true in 2009 for the most successful hedge fund manager, and once again this year, those hedge fund managers who aren't getting subpoenas for insider trading -- as SAC Capital Advisors did on Nov. 24 -- have much to be thankful for.

Now, thanks to some assistance from a former hedge fund research manager, you can consider whether to follow the investing lead of the richest hedge funds. Below, we present a list of the 10 best stock picks of the 10 highest-paid hedge fund managers.

According to AR Absolute Return, the 10 highest-paid hedge fund managers of 2009 were:

  • Appaloosa Management's David Tepper ($4 billion in 2009 compensation)

  • Soros Capital Management's George Soros ($3.3 billion)

  • Renaissance Technologies' James Simons ($2.5 billion)

  • Paulson & Co.'s John Paulson ($2.3 billion)

  • SAC Capital's Steve Cohen ($1.4 billion)

  • Icahn Capital's Carl Icahn ($1.3 billion)

  • ESL's Eddie Lampert ($1.3 billion)

  • Citadel Advisors' Ken Griffin ($900 million)

  • Centaurus Advisors' John Arnold ($900 million)

  • Harbinger Capital's Phil Falcone ($825 million)

Our ex-insider in this endeavor is Joshua Rothschild, who managed the trading desk and systems development for Flagg Street Capital, an investment adviser and hedge fund manager. Today, he's the president of the online marketing firm Applied Interactive. Rothschild analyzed the third quarter 2010 SEC 13F filings of these and 15 other top hedge funds, and picked out their bigger stock holdings (at least 1% of total) to which they had added during the quarter.

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Next, Rothschild applied a method for picking stocks called the Magic Formula -- invented by investor Joel Greenblatt and described in his Little Book that Beats the Market. The Magic Formula ranks stocks based on a percentage that is calculated by ranking stocks on two factors:

  • High Return on Capital Employed (RoCE) as measured by earnings before interest and taxes (EBIT) divided by the total of net fixed assets plus working capital); and

  • Low Valuation -- counted by their earnings yield (EY) which is calculated by dividing EBIT by enterprise value (the market value of stock plus debt minus cash).

Greenblatt claims that the Magic Formula beats the S&P 500 96% of the time, and has averaged a 17-year annual return of 30.8%. Pulling the data from Bloomberg, Rothschild ranked the stocks based on that percentage. As he emailed me on Nov. 24, "I individually ranked the RoCE and EY values 1-100%. I averaged the two scores and ranked those values 1-100% to create the final overall ranking. For instance, Raytheon (RTN) had highest combined ranking with an RoCE of 47.5 (88th percentile) and EY of 17.9% (99th percentile)."

Here are the top 10 stocks:

  • Raytheon (RTN) (100%). This defense contractor's RoCE was 47.5% and it has an EY of 17.5%. Duquesne, whose Stanley Druckenmiller made $450 million in 2009, owns 1 million shares.

  • Microsoft (MSFT)(99%). RoCE: 57.2%, EY: 13.7%. Appaloosa owns 2.8 million shares.

  • General Dynamics (GD)(98%). RoCE: 46.7%, EY:14.7%. Duquesne owns 823,000 shares

  • Wellpoint (WLP)(96%) RoCE: 40.6%, EY: 37.7%. Duquesne owns almost 608,000 shares

  • Medtronic (MDT)(95%) RoCE: 57.2%, EY: 11%. Appaloosa owns 1.4 million shares.

  • Altria Group (MO)(94%) RoCE: 410.5%. EY: 9.8%. Duquesne owns 5.6 million shares.

  • Hewlett Packard (HPQ)(93%) RoCE: 52.1%, EY: 9.9%. Appaloosa owns 3.7 million shares and Harbinger holds16 million shares.

  • Mckesson (MCK) (92%) RoCE: 31.3%, EY: 13.4%. Och-Ziff Capital, whose Daniel Och made $390 million in 2009, owns more than 1 million shares.

  • Constellation Energy (CEG)(91%) RoCE: 30.7%, EY:14.7%. SAC owns 3 million shares.

  • Hewitt Associates(89%) RoCE: 27.3%, EY: 14%. Paulson owns 7.6 million shares.

If you don't want to rely solely on Greenblatt's formula, there are other indicators you might consider analyzing. For example, you could see whether each company's price/earnings to growth (PEG) ratio is less than 1 -- which I view as a sign that a stock is underpriced -- by dividing its P/E by its earnings growth rate. You might also do fundamental analysis of the company to assess whether its industry has high profit potential, and the company has a strong and growing competitive position.

But by at least one respectable measure, these 10 stocks may be the best of the best from the best, and that's a good place to start when looking for long-term buy-and-hold opportunities.

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