One Big Investor Loves This Small Stock -- Should You?

DELAFIELD, Wis. (Stockpickr) -- Whenever I see a large investor take a stake in a small-cap company, I perk up and pay full attention. Hedge fund operators and large asset managers don't just buy small-cap stocks on whim. They do a ton of fundamental work and they pick their spots carefully.

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Usually, when these large investors take their stakes, they're doing it for the long haul. Just the disclosure of their position will increase the volatility in the underlying equity dramatically. They know that other traders will gun against them once their moves are made public, so they need to see opportunity for huge returns in the stocks they choose. Often they'll seek out a distressed stocks that they think the market has mispriced.

Small-cap stocks aren't for the faint of heart, so whenever I see a large fund take a significant stake in one, I like to dig into the equity and see how it looks from not just a fundamental perspective but also a technical perspective. If I see positive developments from both angles, I might look to piggyback the large funds' moves.

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One small-cap stock that a large fund took a significant stake in is Town Sports International (CLUB), which, together with its subsidiaries, owns and operates fitness clubs in the Northeast and Mid-Atlantic regions of the U.S. This stock has been absolutely destroyed in 2014 by the short-sellers, with shares off sharply by 54%.

Town Sports International has a market cap of $160 million and an enterprise value of 395 million. This stock trades at a premium valuation, with a trailing price-to-earnings of 38 and a forward price-to-earnings of 76. Its estimated growth rate for this year is -119%, and for next year it's pegged at 200%. This is not a cash-rich company, since the total cash position on its balance sheet is $76.17 million and its total debt is $314.87 million. This stock currently sports a large dividend yield of 11.1%.

As I stated above, shares of CLUB have been hammered lower, dropping sharply from over $14 at the start of year to a recent 52-week low of $5.65 a share. That massive drop has attracted HG Vora Capital Management to the stock, and the firm has revealed a 12.7% stake in CLUB per an SEC filling. HG Vora recently upped its stake in CLUB to 3.1 million shares from its previous position of 1.30 million shares. During its most recent purchases, HG Vora was buying shares of CLUB at around $5.98 to $6.28 a share.

HG Vora Capital Management is an event-driven, value-oriented investment firm, run by Parag Vora, who previously worked at multi-strategy hedge fund Silver Point Capital and was a vice president at Goldman Sachs Group. Regarding its investment in Town Sports International, I think HG Vora is buying up shares here because it sees a deep value situation developing.

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During Town Sports International's last earnings report, the company reported some disappointing figures, including a drop in total member count of 1,000 members, to 496,000 at the end of the first quarter of 2014. This compares with an increase of 2,000 members in the first quarter of 2013. Revenue also dropped by 2.7% in the first quarter of 2014 vs. the first quarter of 2013, and comparable club revenue fell 4.7% in the first quarter of 2014 vs. a drop of 2.4% during the first quarter of 2013. The company blamed its problems on near-term challenges in attracting members and higher-than-anticipated operating expenses driven in large part by cold winter weather in the Northeast.

There's no sugarcoating the poor results and deteriorating fundamentals for Town Sports International, and the stock has reflected that poor performance with shares dropping sharply from 2014 highs. That said, the stock has now entered technically oversold levels, and it pays a very solid dividend. Plus, the company said on its last conference call that it plans to target around 5% of its lower-performing clubs for closure. This company is clearly looking to cut costs and make more strategic investments to help right the ship. If it can achieve that even marginally, then this oversold stock could easily make a powerful move higher off its depressed levels.

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