David Einhorn is one of our favorite hedge fund managers. His fund, Greenlight Capital, has returned 18.9% per year since its inception in 1996. This number used to be over 22% when we first started Insider Monkey 4 years ago. Greenlight Capital’s assets under management has been increasing as its annualized return and alpha have been decreasing. You probably have observed a similar pattern in the entire hedge fund industry. Assets have been increasing and returns and alpha have been decreasing. This isn’t a coincidence.

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When David Einhorn’s Greenlight files its 13Fs, investors usually focus on his largest positions which were Micron (MU) and Apple Inc. (NASDAQ:AAPL) at the end of 2014. However, these are also large-cap stocks that are closely watched and researched by everyone else. Let’s take Apple Inc. We doubt that Einhorn has any informational advantage over other investors when it comes to Apple Inc.  Every single detail or rumor about Apple Inc. is immediately covered by the media. Apple’s products and business model is also well-known and understood by investors. Apple’s competitors are also well known and analyzed. The trick to make money by investing in Apple Inc. is to accurately predict its future sales and profits. We doubt that Einhorn’s analysts have a leg up on the other investors in that department either. So, why does Einhorn invest in Apple Inc. whereas other investors don’t? He explained his thesis as follows in his latest investor letter:

“The new phones appear to be selling at record levels. Earnings per share have grown 20% for the last couple quarters and are likely to accelerate in the near term. AAPL shares remain inexpensive at 14x 2015 estimates and less than 12x net of cash,”

Basically, Einhorn believes that Apple’s earnings will accelerate whereas other investors don’t want to bet on that. Einhorn has been very bullish about Apple for a very long time. In 2012, when the stock was at $700, Einhorn predicted Apple reaching $1000. He painfully watch the stock dwindle down below $400 over the following 12 months. We aren’t saying that Apple will lose nearly half of its value again. All we are saying is that neither we nor Einhorn don’t know what Apple Inc. will do. Why do we say this?

Well, we analyzed the performance of David Einhorn’s large-cap stock picks that were disclosed in historical 13F filings. Einhorn didn’t have more than 2 large-cap stocks in his portfolio every quarter before 2008. When he has managing a much smaller portfolio, he was focusing on much smaller stocks and generating much higher returns. Between 2008 and 2012 he had as many as 9 large-cap stocks in his portfolio at any given point in time (Apple Inc. was one of these stocks). These large-cap stock picks returned an average of 0.23% per month during these 5 years. S&P 500 Index (SPY) returned an average of 0.29% per month during the same period. We also calculated risk adjusted returns using Carhart’s 4-factor model. Einhorn’s large-cap stock picks generated a monthly alpha of negative 4 basis points per month. What does this mean? David Einhorn’s large-cap stock picks, on average, failed to beat the market recently. David Einhorn isn’t an exception either. There are very few hedge fund managers whose large-cap picks generated annual alphas of more than 5 percentage points.

So, if David Einhorn can’t beat the market by investing in large-cap stocks, why is he so famous and how did he generate average annual net returns of 18.9%?

The secret is his small-cap stock picks. He has been investing in small-cap stocks for a very long time. Our dataset covers the 1999-2012 period. Einhorn’s small-cap stock picks returned an average of 121 basis points per month during these 14 years. S&P 500 Index returned only 32 basis points per month during the same period. This means Einhorn was able to beat the market by more than 10 percentage points per year by investing in small-cap picks. You may say “hey, small-cap stocks are riskier and anyone could have done the same by simply investing in small-cap index funds”. That’s why we use Carhart’s 4-factor model to adjust our results by taking into account known factors that affect returns. Einhorn’s 4-factor alpha for his small-cap picks was 55 basis points per month. This is more than 6.5 percentage points annualized.

These results reveal a huge secret about David Einhorn and Greenlight Capital. Einhorn has a significant edge in picking small-cap stocks and has been a rather pedestrian large-cap-stock investor recently.

We developed an investment strategy that invests in some of the most popular small-cap stocks among hedge funds. Between 1999 and 2009 this strategy outperformed the market by an average of 18 percentage points per year. We have been sharing the stock picks of this strategy in real-time since the end of August 2012. The strategy’s picks had a cumulative return of 132% since then. S&P 500 index funds returned less than 55% during the same period. If investors want to piggyback hedge funds like Greenlight Capital, they should focus on their small-cap stock picks.

At the end of 2014 Einhorn’s top three small-cap picks were Aecom (NYSE:ACM), On Semiconductor Corp (NASDAQ:ONNN), and Take Two Interactive Software Inc. (NASDAQ:TTWO). Among these three stocks Take Two Interactive Software Inc. was the most popular among hedge funds. At the end of December there were a total of 34 hedge funds with bullish positions in the stock. Joel Greenblatt and Spencer Waxman had large positions in the stock.

On Semiconductor Corp is next in line with a total of 28 hedge funds. Billionaire Steve Cohen, Josh Resnick, and Dmitry Balyasny initiated brand new positions in the stock during the fourth quarter. Finally, Aecom (ACM) was in 24 hedge funds’ portfolio. Joel Greenblatt’s magic formula was pointing again another Einhorn pick. He increased his ACM bet by 375% during the fourth quarter. Curtis Macnguyen and Thomas Bailard also initiated brand new positions in the stock during the fourth quarter.

We will take a detailed look at these three stocks in the second part of this article. We like these stocks because our David Einhorn indicator has generated strong returns in the past. We believe investors would benefit more if they switch their attention from Apple Inc. to these three small and under-followed stocks.