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How Did Discover Financial Services (DFS) Compare Against Top Hedge Fund Stocks in 2019?

Reymerlyn Martin

While the market driven by short-term sentiment influenced by the accomodative interest rate environment in the US, increasing oil prices and deteriorating expectations towards the resolution of the trade war with China, many smart money investors kept their cautious approach regarding the current bull run in the third quarter and hedging or reducing many of their long positions. Some fund managers are betting on Dow hitting 40,000 to generate strong returns. However, as we know, big investors usually buy stocks with strong fundamentals that can deliver gains both in bull and bear markets, which is why we believe we can profit from imitating them. In this article, we are going to take a look at the smart money sentiment surrounding Discover Financial Services (NYSE:DFS) and see how the stock performed in comparison to hedge funds' consensus picks.

Discover Financial Services (NYSE:DFS) has seen a decrease in hedge fund interest recently. DFS was in 37 hedge funds' portfolios at the end of September. There were 39 hedge funds in our database with DFS positions at the end of the previous quarter. Our calculations also showed that DFS isn't among the 30 most popular stocks among hedge funds (click for Q3 rankings and see the video at the end of this article for Q2 rankings).

So, why do we pay attention to hedge fund sentiment before making any investment decisions? Our research has shown that hedge funds' small-cap stock picks managed to beat the market by double digits annually between 1999 and 2016, but the margin of outperformance has been declining in recent years. Nevertheless, we were still able to identify in advance a select group of hedge fund holdings that outperformed the Russell 2000 ETFs by 40 percentage points since May 2014 (see the details here). We were also able to identify in advance a select group of hedge fund holdings that underperformed the market by 10 percentage points annually between 2006 and 2017. Interestingly the margin of underperformance of these stocks has been increasing in recent years. Investors who are long the market and short these stocks would have returned more than 27% annually between 2015 and 2017. We have been tracking and sharing the list of these stocks since February 2017 in our quarterly newsletter. Even if you aren't comfortable with shorting stocks, you should at least avoid initiating long positions in stocks that are in our short portfolio.

[caption id="attachment_745225" align="aligncenter" width="1613"] Noam Gottesman of GLG Partners[/caption]

Noam Gottesman GLG Partners

We leave no stone unturned when looking for the next great investment idea. For example one of the most bullish analysts in America just put his money where his mouth is. He says, "I'm investing more today than I did back in early 2009." So we check out his pitch. We read hedge fund investor letters and listen to stock pitches at hedge fund conferences. This December, we recommended Adams Energy as a one-way bet based on an under-the-radar fund manager's investor letter and the stock is still extremely cheap despite already gaining 20 percent. Keeping this in mind we're going to view the new hedge fund action surrounding Discover Financial Services (NYSE:DFS).

What does smart money think about Discover Financial Services (NYSE:DFS)?

At the end of the third quarter, a total of 37 of the hedge funds tracked by Insider Monkey held long positions in this stock, a change of -5% from one quarter earlier. The graph below displays the number of hedge funds with bullish position in DFS over the last 17 quarters. So, let's examine which hedge funds were among the top holders of the stock and which hedge funds were making big moves.

More specifically, Diamond Hill Capital was the largest shareholder of Discover Financial Services (NYSE:DFS), with a stake worth $299.2 million reported as of the end of September. Trailing Diamond Hill Capital was AQR Capital Management, which amassed a stake valued at $153 million. Arrowstreet Capital, GLG Partners, and Balyasny Asset Management were also very fond of the stock, becoming one of the largest hedge fund holders of the company. In terms of the portfolio weights assigned to each position Factorial Partners allocated the biggest weight to Discover Financial Services (NYSE:DFS), around 2.55% of its 13F portfolio. Diamond Hill Capital is also relatively very bullish on the stock, setting aside 1.59 percent of its 13F equity portfolio to DFS.

Due to the fact that Discover Financial Services (NYSE:DFS) has faced bearish sentiment from the entirety of the hedge funds we track, logic holds that there was a specific group of fund managers that elected to cut their full holdings in the third quarter. At the top of the heap, Brandon Haley's Holocene Advisors said goodbye to the biggest stake of the 750 funds watched by Insider Monkey, worth an estimated $26.7 million in stock. Phill Gross and Robert Atchinson's fund, Adage Capital Management, also dropped its stock, about $24.6 million worth. These transactions are interesting, as total hedge fund interest dropped by 2 funds in the third quarter.

Let's check out hedge fund activity in other stocks - not necessarily in the same industry as Discover Financial Services (NYSE:DFS) but similarly valued. These stocks are Cummins Inc. (NYSE:CMI), Coca-Cola European Partners plc (NYSE:CCEP), TD Ameritrade Holding Corp. (NASDAQ:AMTD), and Fiat Chrysler Automobiles NV (NYSE:FCAU). This group of stocks' market valuations are similar to DFS's market valuation.

[table] Ticker, No of HFs with positions, Total Value of HF Positions (x1000), Change in HF Position CMI,31,857313,-14 CCEP,16,125523,6 AMTD,29,334275,7 FCAU,27,1493339,-1 Average,25.75,702613,-0.5 [/table]

View table here if you experience formatting issues.

As you can see these stocks had an average of 25.75 hedge funds with bullish positions and the average amount invested in these stocks was $703 million. That figure was $936 million in DFS's case. Cummins Inc. (NYSE:CMI) is the most popular stock in this table. On the other hand Coca-Cola European Partners plc (NYSE:CCEP) is the least popular one with only 16 bullish hedge fund positions. Compared to these stocks Discover Financial Services (NYSE:DFS) is more popular among hedge funds. Our calculations showed that top 20 most popular stocks among hedge funds returned 41.1% in 2019 through December 23rd and outperformed the S&P 500 ETF (SPY) by 10.1 percentage points. Hedge funds were also right about betting on DFS as the stock returned 47.8% so far in 2019 (through 12/23) and outperformed the market by an even larger margin. Hedge funds were clearly right about piling into this stock relative to other stocks with similar market capitalizations. Video: Click the image to watch our video about the top 5 most popular hedge fund stocks.

5 Most Popular Stocks Among Hedge Funds

Disclosure: None. This article was originally published at Insider Monkey.

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