Bank of America, Microsoft Lure Hedge Funds

Hedge fund managers such as John Paulson and David Tepper are taking advantage of cheap Bank of America, Pfizer and Microsoft shares.
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NEW YORK (

TheStreet

) - Following the smart money is usually a fairly good idea and you can't get much smarter than hedge funds.

According to filings with the Securities and Exchange Commission, hedge-fund managers such as

Paulson & Co.

and

Appaloosa Management

were holding

Dow

stocks such as

Bank of America

(BAC) - Get Report

,

Microsoft

(MSFT) - Get Report

and

Pfizer

(PFE) - Get Report

as of March 31. These stocks offer cheap prices, one of the main draws for hedge funds.

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By identifying undervalued securities and piling into them before the rest of the market, hedge funds have been able to gain during the credit crisis. Many investors irrationally sold securities at insanely low prices out of fear, and hedge funds stepped in to ride the correction.

Big names such as

Seth Klarman

of

The Baupost Group

and John Paulson of Paulson & Co. have seen their assets grow by an incredible amount thanks to the returns they scooped up amid the panic selling. While many may vilify these men for betting against overpriced assets, no one could fault them for going long because they see value in beaten down stocks.

The case for a long position in Bank of America looks pretty clear based on its shares, which are trading at a discount to book value. With a price-to-book ratio of 0.77 versus an industry average of 1.33, Bank of America looks cheap. The stock is also undervalued based on its price-to-free-cash-flow, forward price-to-earnings and price-to-sales ratios. The price-to-free-cash-flow ratio in particular looks very attractive at 1.5 versus 5.7 for the industry.

A holding like Microsoft, which David Tepper's Appaloosa Management holds, could be a better bet for smaller, more risk-averse investors, because the stock is less risky than Bank of America, which still carries a good deal of uncertainty. Microsoft is also trading at a discount to earnings and free cash flow with a forward P/E ratio of 13, versus 24 for the industry, and a price-to-free-cash-flow ratio of 12, versus 22 for the industry. These levels are higher than those for Bank of America, but the stock is in a more stable industry at the moment, which makes the stock trade at a higher multiple.

Paulson and Tepper hold Pfizer. The stock's forward P/E ratio is 7.1, a big discount to the industry's ratio of 14. With a price-to-book ratio of 1.4, the company appears less than half as expensive as the industry, whose average is 3.4.

The investment rationales of top hedge funds go beyond simple ratio analysis, so it's important to supplement these figures with a picture of the business. It's possible for a stock to trade at a cheap multiple because the company is slowly falling apart or the industry's future looks dim.

Incorporating Warren Buffett-style strategies, such as selecting companies with defensible "moats" and a strong position in the industry, will help separate the strong but undervalued from the weak and getting weaker. Value investors usually need a long holding period to see the value of their picks, so be ready to buy companies that you are comfortable living with for a while. No one has ever made any money by being scared out of a pick by short term fluctuations. One of the biggest determinants in a hedge funds manager's success is his conviction to stick with and have faith in his analysis.

-- Reported by David MacDougall in Boston.

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Prior to joining TheStreet Ratings, David MacDougall was an analyst at Cambridge Associates, an investment consulting firm, where he worked with private equity and venture capital funds. He graduated cum laude from Northeastern University with a bachelor's degree in finance and is a Level III CFA candidate.