Jan. 10, 2013, 12:43 p.m. EST

Farallon Capital's top 5 small-cap picks

By Meena Krishnamsetty

Hedge funds get much of their alpha from small-cap stocks, which makes sense as these names tend to be less widely followed, and as a result, given a certain amount of in-depth research, it is easier to spot an undervalued company.

Investing in the most popular small-cap stock picks among hedge funds has generated an alpha of about 120 basis points per month according to our analysis. Retail investors generally aren't as familiar with these companies either, so the input from notable investors may be particularly welcome, though as with any investment-screen type of strategy, it's important to take at least a brief look at each company before deciding whether or not it is worth further research.

We have gone through the most recent 13F filing from Farallon Capital ( see the full list of stocks the fund reported owning ) and here are five of its largest holdings with market capitalizations between $250 million and $2 billion:

Farallon owned over 12 million shares of Hudson Pacific Properties HPP -0.15% , which is a real-estate investment trust owning office and entertainment related property in California. The stock's dividend yield of 2.4% is not particularly attractive from an income perspective, which is where much of the interest in REITs comes from. However, perceived improvements in the real-estate market, including commercial real estate, have caused the stock to rise 44% since a year ago.

5 stocks insiders are buying like crazy

Town Sports International Holdings CLUB +0.19% , another of the fund's small-cap picks, has about $1 million in daily dollar volume. The fitness-club operator is based in the Northeast under names such as New York Sports Club, Boston Sports Club and Washington Sports Club. Value investor Joel Greenblatthad a small position in the stock.

The stock carries trailing and forward P/E multiples of 16 and 13, respectively; while earnings were up strongly in its most recent quarterly report compared to the same period in the previous year, revenue growth was much more modest. We recommended this stock based on strong insider sentiment a couple of years ago when it was trading at $3.

The fund also liked scientific and electronics instrument company FEI Company FEIC -1.35% , reporting a position of about 600,000 shares. FEI's earnings were up 11% in the third quarter of 2012 vs. a year earlier, but the market appears to be expecting stronger growth than that as the stock trades at 21 times trailing earnings. A number of traders seem to think the company is overvalued, with 10% of the outstanding shares held short. Fisher Asset Management, managed by billionaire Ken Fisher, owned 1.2 million shares at the end of September (check out Fisher's stock picks) .

VCA Antech WOOF +0.14% , an animal health-care and hospital company, was another small-cap stock which Farallon owned. VCA Antech was one of P2 Capital Partners' top stock picks at the end of the third quarter of 2012; the fund is managed by Claus Molle . Revenue and earnings were up at double-digit rates in the third quarter of 2012 vs. a year earlier, though, again the trailing P/E of 19 may have captured much of the company's upside already.

Farallon initiated a position in Halcon ResourcesHK -0.16% , which is an oil and gas exploration and production company. The company is currently struggling with profitability, though Wall Street analysts expect the bottom line to improve substantially in 2013, yielding a forward P/E of 15. Billionaire Ken Griffin's Citadel Investment Group was buying Halcon in the last couple months; in early December, the fund had owned over 11 million shares. Production, and therefore revenue, have been up though underperformance has led the stock down 22% in the last year.