Cutting Buffett Helps Sequoia Fund

By Charles Stein - Dec 29, 2011

 

Sequoia Fund Inc., (SEQUX) recommended by Warren Buffett when it opened, beat the U.S. stock market over the past four decades, in part because a large piece of the fund was invested in his company, Berkshire Hathaway Inc. (BRK/A)
Heeding Buffett’s warning that Berkshire wouldn’t grow as fast as it once did, the managers of the $4.7 billion fund cut their reliance on the stock almost in half in 2010 and put the cash into companies such as Valeant Pharmaceuticals International Inc. (VRX), a drug distributor. Sequoia is beating the pack again this year, gaining 14 percent through Dec. 27, better than 99 percent of value stock funds, according to data compiled by Bloomberg.
“They have the kind of portfolio Buffett might have if he ran a mutual fund,” Steven Roge, a portfolio manager with Bohemia, New York-based R.W. Roge & Co., said in a telephone interview. His firm, which oversees $200 million, holds shares in Sequoia.
Like Buffett, the managers of Sequoia look for high-quality companies with competitive advantages that the fund can hang onto for long periods. While the scale of Buffett’s $68 billion stock portfolio forces him to buy mainly the largest companies, Sequoia is small enough to benefit from investments in mid-sized businesses.
The fund beat 97 percent of peers over the past 10 and 15 years, according to Morningstar Inc. (MORN) in Chicago. From 1970 to 2010 the fund returned 14 percent annually, compared with 11 percent for the Standard & Poor’s 500 Index. In its best year, 1976, the fund gained 72 percent, according to “The Warren Buffett Way” (John Wiley & Sons, 1994) by Robert Hagstrom. It lost 27 percent in its worst year, 2008.

Buffett’s Praise

Sequoia Fund was co-founded in 1970 by Richard Cunniff and William Ruane, a friend of Buffett since both studied under legendary value investor Benjamin Graham at Columbia University in 1951. When Buffett shut down his investment partnership in 1969 to concentrate on Berkshire Hathaway, he recommended that his clients invest with Ruane.
“Bill formed Sequoia Fund to take care of the smaller investor,” Buffett wrote in an e-mailed response to questions. “A significant percentage of my former partners went with him and many of those still living have their holdings of Sequoia.”
Ruane ran an unconventional fund, closing Sequoia to new investors in 1982 because he didn’t want its size to limit what the fund could buy. It opened again in 2008, three years after Ruane’s death.
Ruane also held a concentrated portfolio. In 2003, Sequoia had 75 percent of its money in its top six holdings, according to a regulatory filing.

‘Six Best Ideas’

Ruane believed that “your six best ideas in life are going to do the best,” David Poppe, who now runs the fund together with Robert Goldfarb, said at a May 2011 investor day for Ruane, Cunniff & Goldfarb Inc., the New York firm that advises Sequoia.
Poppe and Goldfarb didn’t respond to a request to be interviewed. The two were named domestic stock managers of the year for 2010 by Morningstar. They are finalists for the same award for 2011.
Since Ruane’s death, the firm has hired more analysts and added more holdings to the portfolio. At the end of 2010, Sequoia held 34 stocks, an all-time high, according to a letter to shareholders in the fund’s 2010 annual report. The same letter explained why Sequoia reduced its stake in Berkshire Hathaway.

Cutting Berkshire

“When Warren Buffett tells the public that Berkshire’s growth rate will slow in the future, it behooves one to listen,” the fund’s managers wrote. Buffett has said on a number of occasions that a company of Berkshire’s size can’t grow at the pace it did when it was smaller.
“We know we can’t do remotely as well in the future as we have in the past,” Buffett said on April 30 at Berkshire’s annual meeting in Omaha.
Berkshire represented 11 percent of Sequoia’s holdings as of Sept. 30, down from 20 percent at the end of 2009 and 35 percent in 2004, according to fund reports.
Sequoia’s Berkshire stake has been a drag on the fund’s returns in recent years, said Kevin McDevitt, an analyst for Morningstar. Over the past five years, Sequoia rose 4.3 percent a year compared with an annual gain of 1 percent for Berkshire. Over 20 years through November, Berkshire outperformed Sequoia by 2.6 percentage points a year.
“There was a time when you could have said they were riding Buffett’s coattails,” McDevitt said in a telephone interview. “That’s not the case anymore.”

Long-Term Investor

A reduced Berkshire stake hasn’t stopped the fund from investing in a style similar to Buffett’s. In 2011, Buffett bought shares of MasterCard Inc. (MA) and International Business Machines Corp. (IBM), two companies Sequoia already owned.
Buffett’s portfolio contains stocks, such as Coca-Cola Co. (KO) and Wells Fargo & Co. (WFC), that he has owned for more than 20 years. Sequoia has holdings, including TJX Cos. (TJX) and Fastenal Co. (FAST), that have been in the fund for at least 10 years, regulatory filings show.
TJX, a Framingham, Massachusetts-based discount retailer, has appreciated at a rate of 14 percent a year in the 10 years ended Nov. 30, compared with 2.9 percent for the Standard & Poor’s 500 Index, according to data compiled by Bloomberg. Fastenal, an industrial supplier based in Winona, Minnesota, gained 20 percent a year.
“As an investor, if you get the people and the business right, you can let a company do the hard work for you for a long time,” Thomas Russo, a partner at Lancaster, Pennsylvania-based Gardner Russo & Gardner, said in a telephone interview. Russo, who worked at Ruane’s firm from 1984 to 1989, manages $4 billion.

‘Good and Bad’

Sequoia’s patience hasn’t always paid off. Mohawk Industries Inc. (MHK), a carpet maker based in Calhoun, Georgia, and a longtime Sequoia holding, lost 19 percent of its value in the past five years as the housing slump depressed carpet sales.
“In the short term, holding Mohawk has been a really poor decision,” Poppe said at the 2009 investor meeting.
Such self-criticism is common at the meetings. At one session, an investment in Porsche Automobil Holding SE (PAH3), the German automaker, was described as a “disaster.” At another, a manager admitted the firm was too timid about buying MasterCard after it went public in 2006.
“They give you the good and the bad,” said Roge, who has attended several of the firm’s investor meetings.
Sequoia’s managers don’t buy many of the largest stocks because the companies are too well-known and too heavily followed on Wall Street. Their preference is to own businesses “where we believe, not always correctly, that we have an edge in information,” they wrote in their 2009 letter to shareholders.

Valeant Stake

Valeant Pharmaceuticals, the fund’s largest holding, had a market value of less than $7.5 billion (VRX) when Sequoia purchased it in the third quarter of 2010, Bloomberg data show. The Mississauga, Ontario, drug company gained 62 percent this year.
At the 2011 investor meeting, the fund’s managers emphasized Valeant’s unusual business model, which focuses on acquiring drugs with a proven track record rather than spending money on research and development. They also praised the firm’s chief executive officer, J. Michael Pearson.
Goldfarb told investors that over time he has become convinced that the right executive is crucial to a business’s success. “We’re betting more on the jockey and a little less on the horse,” he said in May at the fund’s annual meeting.
Sequoia typically has far more cash than the 3.7 percent held by the average U.S. domestic stock fund. At the end of the third quarter, cash represented 27 percent of the fund’s assets, according to data compiled by Bloomberg.

Holding Cash

Other well-known value investors, such as Seth Klarman, founder of Baupost Group LLC, a Boston-based hedge fund, and Robert Rodriguez, the longtime manager of FPA Capital Fund and current CEO of Los Angeles-based First Pacific Advisors, let cash build up when they can’t find enough attractive investments.
“In good markets cash can be a drag, but we have not had many good markets lately,” Dan Teed, president of Wedgewood Investors Inc. in Erie, Pennsylvania, said in a telephone interview. Teed, whose firm manages more than $100 million, including shares of Sequoia, said the fund’s cash was a plus because it means they “aren’t afraid to take a defensive position.”

Debt Dangers

Klarman and Rodriguez have written about the dangers of the increase in U.S. government debt, warning that it could pose a threat to the economy and the stock market if it is not whittled down.
Goldfarb normally ducks questions about macroeconomic issues at annual meetings, saying he has no special insight into the future of the economy, interest rates or the prices of oil and gold.
At the 2011 annual meeting, in response to an investor question, he sounded a gloomy note about deficits.
“My own feeling is that we’re just repeating the housing bubble in a different form,” he said. “We’ve substituted an unsustainable buildup of government debt for what is an unsustainable buildup of consumer debt. This one really feels worse to me and more dangerous. I think we’re living in a time of false prosperity.”