Steven Romick, in his most recent letter to investors of First Pacific Advisors, accurately noted that “it’s not just what you do that can make you money over time, it is what you don’t do”. No matter how philosophical one might find this expression, the bottom line here is always to control your risk/reward ratio. Romick gives a pretty straightforward example with investments in ultra long-term US government bonds. Of course, we don’t know where the interest rates will go in the future, but assuming they go down by 1%, your initial investment will yield approximately 20%. However, keeping in mind that we are operating in an environment of all-time low interest rates, the same 1% change in the reverse direction, which is much more likely, will hurt your bet on the bonds by 18%. Risk/reward ratio here is not on your side, as simple as that. Having introduced the concept, let’s jump on the three «don’t do»’s from the equity world suggested in the letter by Steven Romick. These stocks are W W Grainger Inc (NYSE:GWW), Fastenal Company (NASDAQ:FAST) and Amazon.com Inc (NASDAQ:AMZN). Steven believes that knowing why these securities haven’t made it into his portfolio, will allow the general public to understand his way of thinking, and the challenges for value investors coming from Mr. Market.
First Pacific Advisors was founded back in 1954 as Shareholders Management Company, changing its name to First Pacific Advisors in 1976. As of today the fund is primarily controlled by Robert Rodriguez and Steven Romick. In general, First Pacific manages a number of funds that specialize in different investment strategies like absolute fixed income, contrarian value, global value, international value, small/mid-cap quality, and small/mid-cap absolute value. According to its latest 13F filing, First Pacific concentrated more on the technology sector than any other, allocating around 32.99% of its $12.20 billion public equity portfolio to tech stocks, while finance stocks were next at 21.74%.
Professional investors like Robert Rodriguez and Steven Romick spend considerable time and money conducting due diligence on each company they invest in, which makes them the perfect investors to emulate. However, we also know that the returns of hedge funds on the whole have not been good for several years, underperforming the market. We analyzed the historical stock picks of these investors and our research revealed that the small-cap picks of these funds performed far better than their large-cap picks, which is where most of their money is invested and why their performances as a whole have been poor. Why pay fees to invest in both the best and worst ideas of a particular hedge fund when you can simply mimic the best ideas of the best fund managers on your own? A portfolio consisting of the 15 most popular small-cap stock picks among the funds we track has returned more than 139% and beaten the market by 81 percentage points since the end of August 2012, (see the details).
As for the stocks that we have introduced, Grainger and Fastenal are famous industrial distributors with astonishing historical returns on capital of around 20%. Over the last five years the owners of these companies have seen their bets appreciate by 75% for Fastenal and by 122.29% for Grainger. Such performance is easily justified by attractive gross margins, which are more than twice as high as the industry average of 19.2%. According to our extensive database of hedge fund managers, the top shareholder of Fastenal Company (NASDAQ:FAST) is Ken Griffin’s Citadel Investment Group. After a dramatic increase in his position by 526,000%, the fund manager finished the first quarter of the year with 1.72 million shares valued at $71.28 million. Generation Investment Management, led by David Blood and Al Gore heads the list of investors in W W Grainger Inc (NYSE:GWW), holding some 1.4 million shares worth $330.15 million.