7 Stocks the World's Greatest Hedge Fund Managers Love

Niccolo Machiavelli put it best:

A prudent man should always enter by the paths beaten by great men and imitate those who have been most excellent, so that, if his own skill does not come up to theirs, at least it will give off something of the odor of theirs.

Follow the smart people. Watch what they do. Learn from them. Copy their ideas. Simple stuff that can provide a good foundation for success.

Lucky for us, large investors like hedge funds are required to report their holdings every quarter. While slightly dated, this information gives us an inside peek into what some of the smartest minds in the investment world are up to.

Using data from the tracking firm AlphaClone, I set out to find the top seven stocks that have attracted the most capital from hedge funds. Using an index of the 196 largest funds, here's what I found:

Source: AlphaClone.

Let's say a few words about these companies.

Apple
Apple's earnings growth -- 50% per year over the past five years -- is well-known and well-hyped. How that growth fits into the stock's valuation isn't as glorified. Shares trade at about 15 times forward earnings, which itself looks pretty attractive. But the bigger picture is even rosier. Apple's balance sheet is stuffed full of cash, and the company is completely debt-free. So although its market cap is $244 billion, its enterprise value is much less -- about $215 billion. Back out the cash, and Apple trades at a mere 12 times forward earnings. It is, in many ways, one of the fastest-growing large-cap companies on Earth, trading as if it were merely average, if not slightly below average.

Big banks
Bank of America, JPMorgan, and Citigroup are heavily owned by top hedge funds, but it's really one fund -- Paulson & Co. -- that has gone in headfirst. Of the amounts shown in the table above, Paulson & Co. alone makes up $2.4 billion of Bank of America and $1.9 billion of Citigroup. (Paulson & Co. is run by John Paulson, who made a bloody fortune shorting the housing market.)

One recent development that makes big banks more interesting is the updated Basel capital requirements. The new internationally agreed-upon rules require banks to hold higher minimum capital. Bank of America, JPMorgan, and Citigroup already hold more than the updated minimums, so the new rules don't mean much for them. Uncertainty over capital rules, however, is now removed, upping the odds that dividends will resume at normal levels in the near future. Owning bank stocks still makes me nauseated because it's so easy for the companies to distort reality, but hedge funds apparently feel differently. More power to 'em.

ExxonMobil
Something ain't right at ExxonMobil: The stock trades lower today than it did during the deepest depths of the financial crisis -- a time when crude was less than half today's price. The company trades at nine times forward earnings, spits off a 3% dividend, and in 2009 bought back stock worth more than twice what it paid out in dividends. Put another way, if ExxonMobil stopped repurchasing shares, it could have been paying what amounts today to a 9% dividend.

Why are shares suddenly so cheap? The most logical explanation is that BP's oil disaster turned investors away from the entire industry. At a recent conference I attended, an oil analyst noted that the insurance industry placed the odds of a large rig blowing up at zero percent before the BP spill. So this industry's risks are now being reevaluated. Still, current valuations seem patently ridiculous and provide plenty of room for error.

Pfizer
The tides have shifted: Bonds are now the preferred vehicle of capital growth; stocks are where you find income. Sheer madness, I'm aware. But that's today's world. Better to face reality than laugh at it.

Pfizer's 4.2% dividend is one of the market's most attractive. Not necessarily because of its amount -- higher yields can be found. But the amount Pfizer pays out as dividends equals only about one-third of its 2009 free cash flow. So not only is this dividend high, but it's fairly safe based on historical cash flow. That's an attractive combination. 

Microsoft
Back out the cash, and Microsoft trades at roughly eight times forward earnings. "That's insanely cheap for a company of this caliber and market position" says hedge fund manager Whitney Tilson.

I agree. Take a stock with a thick moat, add in a bulletproof balance sheet, and mix in a valuation that's way below market averages and you're not likely to end up disappointed. Microsoft is a great example of what investors should be looking for these days: an established large cap with tons of cash, a business model not dependent on discretionary consumer spending, and broad geographic exposure. Double dip or otherwise, those kinds of companies will keep chugging along.

Thoughts? Comments? Fire away in the comments section below.

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