3 stock picks from the next David Einhorn

By Meena Krishnamsetty

There are two ways of taking advantage of the investment prowess of hedge fund managers. Our research has discovered that the most popular stocks among hedge funds have historically outperformed the S&P 500 index by 18 percentage points per year. This sounds impressive — but we also wanted to see whether these historical results would persist.


So we launched a newsletter at the end of August and shared the stock picks of this strategy. Our stock picks gained more than 35% since then vs. S&P 500 index's 12% return.

Another way of investing in hedge funds is picking hedge fund managers with outstanding track records. We recently came across an under-the-radar hedge fund manager who can produce alpha both on the long side and the short side of his portfolio. Our quantitative analysis shows that his alpha is even slightly better than David Einhorn's.

Michael Castor of Sio Capital Management, LLC is a medical doctor (he used to be a surgeon) by training, but switched to finance in mid 2000. He worked as a health-care analyst at JPMorgan and Bernstein Investment Research and Management until he launched Sio Capital in 2006.

Academic studies have shown that small hedge funds and hedge funds focusing on a specific sector perform better than other hedge funds.

Sio Capital returned 10.4% a year since its inception vs. 3.8% average annual gain for the S&P 500 Total Return Index during the same period. But this isn't why we like Sio Capital. We like Sio Capital because they achieved a 6.6 percentage-point outperformance with a nearly market neutral portfolio. Its beta was 0.15 since inception. Sio Capital was also 12% net short in 2012, yet it returned 14.9% after fees and expenses.

This is what we call alpha.

One of Michael Castor's favorite large-cap stock picks is Cardinal Health CAH -0.22% , a drug distributor. Cardinal will benefit from the wave of branded drugs going generic because distributors make more from distributing a generic prescription than a branded one. We should note that Wall Street is quite bearish about Cardinal, but billionaires Andreas Halvorsen, Steve Cohen, and Ken Griffin are among CAH shareholders. Here is what Castor said about this stock in a recent interview with Insider Monkey:

"The valuation of Cardinal is attractive, trading at about 12 times. Cardinal has an overhang, in that a large contract with CVS is up for renewal. Cardinal distributes what's known as 'bulk' product to CVS, meaning huge crates of drugs to central locations. This is in contrast to the work Cardinal does for individual drug stores, where the company will drop off small volumes of drugs as the pharmacy needs them.

“In the case of 'bulk', CVS does the work of redistributing products to the individual store branches. Because Cardinal is simply delivering large crates, the mark-up and profit is small. So, on a revenue basis, it looks like it's a big chunk of revenue that is at risk, but on an earnings basis, it's much less significant."

Castor says he thinks Cardinal has a good chance of renewing the contract. And if they don't, Castor says it's not a significant impact to the stock's earning power and valuation. "It's a great stable business. It's a tremendous cash-flow generator and so the combination of attractive valuation, an investment story that just makes sense to me, expectation of meeting their earnings targets and potentially even upward revision to their earnings estimates on the removal of this overhang. That constellation of factors makes Cardinal my favorite investment right now. My favorite large cap," he added.

The contract renewal should be announced any day. Castor acknowledged that the loss of the CVS contract would be negative for investor sentiment and indicated that he has purchased put options for protection against his losses.

Michael Castor also has large positions in CarefusionCFN +0.20% , Covidien PLC COV +0.53% and GlaxoSmithKline PLC GSK +1.14% .

Michael Castor's favorite small-cap idea performed extremely well since our interview. NPS PharmaceuticalsNPSP +3.60% returned more than 25% over the last month. Here is Castor's investment thesis:

"NPS has three legs that really underpin their revenue. The first one is a set of royalties that they get, with the biggest being on Sensipar, a drug sold by Amgen. It's a very stable drug that generates about $90 million of revenue for NPS on an annual basis and will continue to do so until the drug goes generic around the 2017/2018 timeframe.

"The second source of revenue is a drug that is just now being launched for an indication called short-bowel syndrome. This condition is what's known as an orphan disease. The condition can occur for a number of reasons. Some patients have experienced trauma such as a gunshot wound to the abdomen; others need to have a lot of their intestine surgically resected due to various diseases. In any case, patients are left with a short stub of intestine. Because it's so short, they can't absorb enough food. Food passes right through their intestine. As a result, they need to be on IV nutrition. It's called TPN or Total Parenteral Nutrition.

"The NPS drug that has just been approved is called Gattex, and it causes proliferation of the lining of the intestines. This means the lining has more absorptive surface area and which allows them to cut down on their IV nutrition and even potentially wean off of it completely.

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