2 Small-Cap Stocks Hedge Funds Love

See if either stock makes sense for your portfolio.

Jul 17, 2014 at 5:15PM

CreditDr. Partha Sarathi Sahana, Flickr.

Exchange-traded funds offer a convenient way to invest in sectors or niches that interest you. If you'd like to add some promising small-caps companies to your portfolio but don't have the time or expertise to hand-pick a few, the Global X Guru Small Cap Index ETF (NYSEMKT: GURX) could save you a lot of trouble. Instead of trying to figure out which stocks will perform best, you can use this exchange-traded fund to invest in lots of promising small-cap companies simultaneously.

Why this ETF and why small-caps favored by hedge funds?
It's always good to include some small-cap stocks in a diversified portfolio, because while they may carry more risk than large-cap stocks, they also tend to have more growth potential. This ETF offers instant exposure to an intriguing bunch of small-cap companies -- ones that are heavily favored by hedge fund managers and institutional investors. Such stocks have been well researched by deep-pocketed outfits and are among their highest-conviction holdings.

This ETF sports an expense ratio, or annual fee, of 0.75%, well below the typical mutual fund's fees. It's small, too, because it's new, so if you're thinking of buying, beware of possibly large spreads between its bid and ask prices. Consider using a limit order if you want to buy in.

A closer look at some components
On your own you might not have found or selected Halozyme Therapeutics (NASDAQ:HALO) or Depomed Inc (NASDAQ:DEPO) as promising small-cap companies for your portfolio, but this ETF recently counted them among its 100 holdings.

Halozyme Therapeutics
Halozyme investors have been on a wild ride, with the stock up 40% from its 52-week low and also down nearly 50% from its 52-week high. The biopharmaceutical company commercializes human enzymes, including ones that help deliver drugs into the bloodstream. That technology is of great interest to doctors and patients, permitting drugs to be injected quickly via a shot instead of a lengthy intravenous infusion.

Halozyme's proprietary subcutaneous delivery technology Hylenex has been approved in the U.S., and the company has other formulations, tackling diabetes and pancreatic cancer, approaching late-stage trials. Its pipeline also features several collaborative formulas approved in Europe, including HyQvia, which targets immunodeficiency and involves a partnership with Baxter International, and two Roche partnerships, tackling breast cancer and non-Hodgkins lymphoma. There are also up to six treatments in early clinical trials through a partnership with Pfizer.

There's much to like about Halozyme, such as its big, deep-pocketed partners, but with a price-to-sales ratio recently near 19, the stock seems far from a bargain, at least considering that much of its potential is resting on not-yet-approved products. Interested investors should probably wait for a pullback in price, some additional treatment approvals, or profitability instead of losses, which are expected by some to happen within a year or so.

Unlike Halozyme, Depomed has posted several years' worth of profits, and its top line is growing briskly. The company develops products to treat pain and other central nervous system conditions. It has four of its own products already approved and on the market (tackling postherpetic neuralgia and migraines, among other things), along with two that involve partnerships.

Depomed's stock took a big hit in May when it posted disappointed first-quarter earnings and forecast full-year earnings well short of Wall Street expectations. (In previous quarters, it had surpassed expectations.) A key reason for the shortfall was weak sales of Depomed's main offering, pain medicine Gralise, reportedly owing to inventory issues and bad weather -- which are, importantly, short-term issues, not prolonged, intractable ones. Still, Gralise sales grew by 79% year over year, which isn't too shabby. The company recently raised the price on Gralise, so it remains to be seen if that will have an adverse effect on sales.

The stock looks more reasonably priced than Halozyne, as it sports a P/E ratio near 11, but its price-to-sales ratio of 4.4 is still well above the industry average. Depomed is an appealing investment opportunity with a range of products already on the market and selling well, but it's not a screaming bargain at current levels. Consider adding it to a watchlist, though.

The big picture
It makes sense to consider adding some promising small-cap companies to your portfolio. You can do so easily via an ETF. Alternatively, you might simply investigate its holdings and then cherry-pick from among them after doing some research on your own.

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Longtime Fool specialist Selena Maranjian, whom you can follow on Twitter, has no position in any stocks mentioned. The Motley Fool recommends Baxter International. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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