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Was The Smart Money Right About Discover Financial Services (DFS)?

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  • DFS

In this article we are going to use hedge fund sentiment as a tool and determine whether Discover Financial Services (NYSE:DFS) is a good investment right now. We like to analyze hedge fund sentiment before conducting days of in-depth research. We do so because hedge funds and other elite investors have numerous Ivy League graduates, expert network advisers, and supply chain tipsters working or consulting for them. There is not a shortage of news stories covering failed hedge fund investments and it is a fact that hedge funds' picks don't beat the market 100% of the time, but their consensus picks have historically done very well and have outperformed the market after adjusting for risk.

Is Discover Financial Services (NYSE:DFS) the right pick for your portfolio? Money managers were taking a bearish view. The number of bullish hedge fund bets retreated by 8 in recent months. Discover Financial Services (NYSE:DFS) was in 37 hedge funds' portfolios at the end of June. The all time high for this statistic is 52. Our calculations also showed that DFS isn't among the 30 most popular stocks among hedge funds (click for Q2 rankings). There were 45 hedge funds in our database with DFS holdings at the end of March.

In the financial world there are a large number of tools investors have at their disposal to grade stocks. A pair of the most under-the-radar tools are hedge fund and insider trading indicators. We have shown that, historically, those who follow the top picks of the best fund managers can outperform the broader indices by a solid amount. Insider Monkey's monthly stock picks returned 185.4% since March 2017 and outperformed the S&P 500 ETFs by more than 79 percentage points (see the details here). That's why we believe hedge fund sentiment is a useful indicator that investors should pay attention to.

Peter Rathjens Arrowstreet Capital 394
Peter Rathjens Arrowstreet Capital 394

Peter Rathjens of Arrowstreet Capital

At Insider Monkey, we scour multiple sources to uncover the next great investment idea. For example, lithium prices have more than doubled over the past year, so we are checking out stock pitches like this emerging lithium stock. We go through lists like the 10 best EV stocks to pick the next Tesla that will deliver a 10x return. Even though we recommend positions in only a tiny fraction of the companies we analyze, we check out as many stocks as we can. We read hedge fund investor letters and listen to stock pitches at hedge fund conferences. You can subscribe to our free daily newsletter on our homepage. With all of this in mind let's take a glance at the new hedge fund action encompassing Discover Financial Services (NYSE:DFS).

Do Hedge Funds Think DFS Is A Good Stock To Buy Now?

At the end of June, a total of 37 of the hedge funds tracked by Insider Monkey were bullish on this stock, a change of -18% from the previous quarter. On the other hand, there were a total of 44 hedge funds with a bullish position in DFS a year ago. With hedge funds' positions undergoing their usual ebb and flow, there exists an "upper tier" of noteworthy hedge fund managers who were boosting their holdings substantially (or already accumulated large positions).

More specifically, East Side Capital (RR Partners) was the largest shareholder of Discover Financial Services (NYSE:DFS), with a stake worth $95.8 million reported as of the end of June. Trailing East Side Capital (RR Partners) was Arrowstreet Capital, which amassed a stake valued at $81.2 million. Citadel Investment Group, Millennium Management, 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 East Side Capital (RR Partners) allocated the biggest weight to Discover Financial Services (NYSE:DFS), around 10.32% of its 13F portfolio. Factorial Partners is also relatively very bullish on the stock, setting aside 2.68 percent of its 13F equity portfolio to DFS.

Since Discover Financial Services (NYSE:DFS) has faced falling interest from the entirety of the hedge funds we track, logic holds that there lies a certain "tier" of fund managers who were dropping their full holdings by the end of the second quarter. Interestingly, Ricky Sandler's Eminence Capital said goodbye to the biggest position of all the hedgies monitored by Insider Monkey, totaling close to $91.3 million in stock. Michael Gelband's fund, ExodusPoint Capital, also sold off its stock, about $11.2 million worth. These bearish behaviors are intriguing to say the least, as aggregate hedge fund interest dropped by 8 funds by the end of the second quarter.

Let's check out hedge fund activity in other stocks similar to Discover Financial Services (NYSE:DFS). We will take a look at The Hershey Company (NYSE:HSY), ResMed Inc. (NYSE:RMD), XPeng Inc. (NYSE:XPEV), Cummins Inc. (NYSE:CMI), Xilinx, Inc. (NASDAQ:XLNX), TransDigm Group Incorporated (NYSE:TDG), and Xcel Energy Inc (NASDAQ:XEL). All of these stocks' market caps resemble DFS's market cap.

[table] Ticker, No of HFs with positions, Total Value of HF Positions (x1000), Change in HF Position HSY,38,1229056,-4 RMD,26,428212,1 XPEV,19,784609,0 CMI,45,1102223,8 XLNX,59,4162249,2 TDG,57,7351832,-5 XEL,22,235410,4 Average,38,2184799,0.9 [/table]

View table here if you experience formatting issues.

As you can see these stocks had an average of 38 hedge funds with bullish positions and the average amount invested in these stocks was $2185 million. That figure was $451 million in DFS's case. Xilinx, Inc. (NASDAQ:XLNX) is the most popular stock in this table. On the other hand XPeng Inc. (NYSE:XPEV) is the least popular one with only 19 bullish hedge fund positions. Discover Financial Services (NYSE:DFS) is not the least popular stock in this group but hedge fund interest is still below average. Our overall hedge fund sentiment score for DFS is 40.8. Stocks with higher number of hedge fund positions relative to other stocks as well as relative to their historical range receive a higher sentiment score. This is a slightly negative signal and we'd rather spend our time researching stocks that hedge funds are piling on. Our calculations showed that top 5 most popular stocks among hedge funds returned 95.8% in 2019 and 2020, and outperformed the S&P 500 ETF (SPY) by 40 percentage points. These stocks gained 29.6% in 2021 through November 5th and surpassed the market again by 3.1 percentage points. Unfortunately DFS wasn't nearly as popular as these 5 stocks (hedge fund sentiment was quite bearish); DFS investors were disappointed as the stock returned -1.2% since the end of June (through 11/5) and underperformed the market. If you are interested in investing in large cap stocks with huge upside potential, you should check out the top 5 most popular stocks among hedge funds as most of these stocks already outperformed the market in 2021.

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