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Sequoia Fund Annual Letter to Shareholders (2011) and Discussion of Major Holdings
Posted by: CanadianValue (IP Logged)
Date: March 6, 2012 10:09AM
When Warren Buffett folded up his investment partnership more than 40 years ago he recommended one fund to his investors: the Sequoia Fund, which was managed by his friend Bill Ruane.
Here we are 40 some years later and the Sequoia Fund is still beating the market, and still holds a significant position in Buffett’s Berkshire Hathaway (BRK.A)(BRK.B).
Interestingly, in 2011 it seems that the main challenge that the Sequoia Fund had was being overwhelmed by inflows from new investors after Morningstar named them fund manager of the year in 2010.
You would think that the 40-year track record of Sequoia would have been more interesting to potential investors than being named manager of the year for one trip around the sun.
The 10 largest positions in the Sequoia Fund represent over 50% of invested assets, so the fund is still managed in a concentrated value style like it was by Bill Ruane years and years ago.
To the Shareholders of Sequoia Fund, Inc.
Sequoia Fund’s results for the quarter and year ended December 31, 2011 appear below with comparable results for the S&P 500 Index:
The performance shown above represents past performance and does not guarantee future results. The table does not reflect the deduction of taxes that a shareholder would pay on Fund distributions or the redemption of Fund shares. Current performance may be lower or higher than the performance information shown.
* The S&P 500 Index is an unmanaged, capitalization-weighted index of the common stocks of 500 major U.S. corporations. The performance data quoted represents past performance and assumes reinvestment of distributions. The investment return and principal value of an investment in the Fund will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Year to date performance as of the most recent month end can be obtained by calling DST Systems, Inc. at (800) 686-6884.
The Fund outperformed the S&P 500 Index for the fourth quarter and the year. While the stock market posted modest gains in 2011, an investor in the Index still would not have recovered his losses from 2008, when the Index declined 37%. Over the past five years, the Index has generated a slightly negative overall return while Sequoia has compounded at a 4.3% annual rate, net of fees.
Sequoia has generated this return while operating with roughly 15% to 20% of our assets in cash for most of the past four years. We were pleased with the 13.2% gain in the Fund for the year but recognize that our performance would have been better had we been fully invested in the stocks we already owned.
The high concentration of cash in the Fund in 2011 was not by design. We entered 2011 with a 21% cash position, but were quite active buying securities during the year. Sequoia ended 2010 with 34 stocks in the portfolio. We added a net of 12 positions in 2011, bringing us to 46 stocks. Overall, the Fund began the year with a bit less than $3.5 billion of assets under management and was a net purchaser of $643 million of equities during the year.
However, we were surprised by the inflow of money into the Fund that occurred after we were named last January as domestic equity fund managers of the year for 2010 by Morningstar. In 2011 investors contributed $930 million to Sequoia, net of withdrawals. We thought the inflow that began immediately after the award would prove temporary, but it remained steady all year. It became a problem in the fourth quarter. Stock market valuations rebounded strongly at the end of the year and our buying activity slowed in response. Yet Sequoia took in more than $275 million during the quarter.
Thus, despite our best efforts we finished 2011with more than $1 billion in cash in the Fund and roughly the same 21% cash weighting as we had at the start. Faced with what are, for now, limited options for deploying capital, we elected in early January to close the Fund to new investment from financial services platforms such as Charles Schwab, TD Ameritrade and E*Trade, as they were accounting for the overwhelming majority of our inflows.
Turning to performance, we experienced broad-based strength from our equities in 2011. Nine of the 10 largest positions in Sequoia outperformed the 2.1% return of the S&P 500 Index.
At year-end, the 10 largest holdings in Sequoia represented 52.8% of the Fund’s assets and nearly two-thirds of our investments in securities. As always, we endeavor to concentrate Sequoia in our best ideas. Though we finished the year with a record number of companies in the Fund, we remain comfortable with our overall level of concentration in the top 10 positions.
As we reported to you last year, we have been steadily adding to our research staff over the past decade. As a result, we have broadened our reach and begun studying dozens of businesses for the first time. In 2011, we added 14 new positions to the Fund and sold two, leaving us with a net addition of 12 securities. As recently as 1999, we had fewer than 12 stocks in the Fund in total.
It is a bit of a paradox that we’re holding so much cash at a time when we own more stocks than ever before. However, we have been cautious buyers and that has resulted in a somewhat lopsided portfolio. The 12 smallest positions in the Fund cumulatively amount to 1.5% of our holdings. Similarly, we made quite a few investments in 2011, but none of them at year-end amounted to more than 1% of the Fund’s assets.
There are several reasons why we hold so many stocks that cumulatively amount to a non-material portion of the Fund’s assets. While we bought a lot of stocks last year, with benefit of hindsight it appears we were a bit too cheap. As stock prices zigged and zagged, we tried to remain disciplined purchasers. We ended up buying tiny amounts of a number of stocks that briefly touched our buy prices and then quickly moved higher. We presumed continued market volatility would create more chances for us to buy shares. Too frequently, however, we ended up bottom-ticking the shares and owning immaterial amounts of stock. In most cases, we’ve opted to continue holding these small positions in the hope that we may get a chance to buy more shares in the future.
Sequoia investors should be prepared to own a portfolio of 50 or more stocks and should not be surprised if a number of these positions amount to “rounding errors.” We like following and owning smaller, more entrepreneurial companies but these stocks can be difficult to buy. It can take weeks of trading to accumulate a full position. As we will not sacrifice price discipline to acquire a stock in size, there will be times when we end up with fractional positions.
Even as the portfolio grows, we expect that a relatively small number of holdings will continue to represent the lion’s share of Sequoia.
Looking ahead, we humbly submit that we have no idea what the stock market will do in 2012. The reader is no doubt aware of the budget situations in the United States, Europe and Japan, and the threat they pose to long-term economic growth in the developed world. The faster growing economies of the emerging world suffer from their own structural inefficiencies that could disrupt their upward path. At the same time, corporate America arguably has never been stronger: profit margins are high, balance sheets are healthy, labor productivity continues to improve faster than wages.
Rather than try to guess what might happen next, we think it more prudent to own a portfolio of market-leading companies that earn high returns on capital, boast strong balance sheets and self-fund their growth. We try to invest in high-quality management teams and to identify businesses with many years of growth ahead of them.
Throughout our history we have preferred to speak to our investors directly and clearly. We meet with Sequoia shareholders once a year, usually in May, and answer questions for several hours. Otherwise, we do not court publicity. We have no marketing arm. As a result, we were perhaps unprepared for the impact the Morningstar award had on the Fund. To our new investors, welcome. Our goal today is the same as it has always been: to own a portfolio of businesses that have been vigorously researched and carefully purchased, which consequently can outperform the broader stock market over many years. We have a proud history but we are looking forward, always.
You should be aware that our large cash position could act as an anchor on returns in a prolonged bull market. Conversely, in a bear market the cash might cushion the blow to stocks and provide us with flexibility to make new investments. Investors should remember that a concentrated portfolio of stocks will not track the results of the S&P Index from year to year. Over time, a well-selected portfolio should outperform the Index. We believe the current portfolio will generate satisfactory returns over time for Sequoia shareholders.
Management’s Discussion of Fund Performance (Unaudited)
The total return for the Sequoia Fund was 13.2% in 2011. This compares with the 2.1% return of the S&P 500 Index. Our investment philosophy is to make concentrated commitments of capital in a limited number of companies that have superior long-term economic prospects and that sell at what we believe are attractive prices. Because Sequoia is deliberately not representative of the overall market, in any given year the performance of the Fund may vary significantly from that of the broad market indices.
The table below shows the 12-month stock total return for the Fund’s major positions at the end of 2011.
The outperformance vs. the Index in 2011 was driven by strong performance of the Fund’s equity holdings. Nine of the Fund’s 10 largest holdings outperformed the Index, and these 10 holdings constituted 52.8% of the Fund’s assets under management at year-end. During the year, investors committed $930 million of cash to the Fund, net of withdrawals. As a result, some securities which performed well during the year declined as a percentage of the Fund’s assets as we failed to buy more shares as cash flowed into the Fund.
At year-end, the Fund was 78.5% invested in common stocks and 21.5% invested in cash and Treasury Bills.
Our largest holding, Valeant, had a busy year. Many of its end markets and products grew nicely. Overall, we believe Valeant generated about 8% organic revenue growth in 2011, led by its U.S. Dermatology unit that grew more than 20%. Full year numbers have not been reported yet, but we estimate that the European, Canada/Australia, and Latin America divisions will also generate double digit organic growth in 2011. This growth was partially offset by declines in the U.S. Neurology and Other division, led notably by a double digit decrease in sales of the antidepressant Wellbutrin XL.
On the acquisition front, Valeant (VRX) was involved in several transactions including PharmaSwiss, Sanitas, Ortho Dermatologics, Dermik, and iNova. The PharmaSwiss and Sanitas acquisitions should increase Valeant’s European business to well over $600 million in revenues in 2012, which would put Europe at close to 20% of the total business. Ortho Dermatologics and Dermik will help Valeant become one of the leading dermatology companies in the world with over $1 billion in revenues. iNova increased Valeant’s presence in Australia and helped it establish footholds in South Africa and Southeast Asia. Management is optimistic that the new positions in Southeast Asia, South Africa and Russia represent future growth platforms for Valeant.
As we discussed in last year’s report, we like Valeant’s approach to the pharmaceutical business. In an industry marked by heavy spending on unproductive research and development, Valeant over a period of years has acquired a stable of older branded drugs, generic and OTC drugs. Many of its drugs are steady sellers in niche categories of dermatology or neurology. In our view, Valeant is essentially a value investor in pharmaceutical products.
Berkshire Hathaway’s look-through earnings likely improved only slightly in 2011, but this may mask a more impressive increase in earnings power. Berkshire’s sometimes volatile insurance underwriting profits declined sharply due to record global catastrophe losses, with two devastating earthquakes in New Zealand and Japan, record floods in Thailand, and heavy losses from US tornados.
Despite these unusually high catastrophe losses, Berkshire’s underlying performance improved. GEICO’s voluntary auto policy sales increased at double digit rates and retention was up, a medical malpractice unit was acquired, and Gen Re bid for an Asian life company, all building a platform for stronger future results. Outside the insurance units, Berkshire spent more than $10 billion to buy Lubrizol and an additional 16.5% interest in Marmon, both of which will add to future earnings power. We think the investment portfolio grew in size. While $11 billion of high-yielding securities in Goldman Sachs, GE and Swiss Re were called away, Berkshire spent an equal amount on IBM common generating look-through earnings equal to the lost investment income.
The rest of the company’s profits rose at a mid-teens rate as the large non-insurance units — the Burlington Northern railroad, IMC Metalworking, the mini-conglomerate Marmon, and Midamerican Energy — all generated fine results. Operating profits were boosted by the partial-year ownership of Lubrizol and the larger share of Marmon. At year-end, Midamerican spent $3 billion for two Western solar facilities that have long-term contracts to sell electricity to California utilities at premium prices. Berkshire also bought back shares to take advantage of an historically low valuation.
We have held shares of TJX (TJX) in the Fund for 11 years. The company has been a very good performer for a long time, but earnings growth has accelerated in recent years. TJX is the largest off-price apparel and home goods retailer in the United States, Canada and the UK and has a presence in Poland and Germany. The long-term struggle of U.S. department stores to remain relevant to shoppers has been a boon to TJX. As apparel vendors search for new channels for growth, off-price retailers have become increasingly powerful in the marketplace. TJX not only continues to source high-quality goods from a vast roster of vendors, it has enjoyed steadily rising margins for several years as it buys goods on favorable terms. In 2007, TJX earned $0.84 per share. We believe earnings per share for 2011, which will be reported later in February, will approach $2.00, accounting for a recent stock split. This would represent a four-year growth rate of 24%. We don’t expect this kind of growth to continue indefinitely, but TJX earns extremely high returns on capital, enjoys ample free cash flows and returns most of that free cash to its owners in the form of dividends and stock buybacks. We believe there is room to grow the store base by roughly 5% per year for several more years, and the company typically repurchases 4% – 6% of its shares annually, leaving it well-positioned to keep growing earnings at low-double digit rates.
We have held shares in Fastenal (FAST), a broad-line industrial distributor with a specialty in industrial fasteners, for 11 years. Fastenal’s 2011 results provided a worthy encore to its outstanding performance in 2010. Revenue increased by 21.9%, and Fastenal’s exceptionally energetic and frugal management team leveraged that result into a 34.8% increase in net income. At the end of 2011, Fastenal operated 2,585 branch locations, and as the law of large numbers takes hold, the company relies less and less on new store openings to drive its growth. However, the company continues to find creative ways to invest in its store base so that its branches grow faster than GDP for many years after they are opened. In 2009, the company embarked on an effort to automate the sale of certain industrial products by installing vending machines and automated lockers at customer work sites. These machines make the sales process more efficient and save money for Fastenal’s customers by reducing waste at the point of sale. In the first two years of the program, Fastenal installed 1,925 machines at customer locations. In 2011, it installed 5,528 machines and built the capacity to install 10,000 annually in the future. Though still in its early stages, Fastenal’s automated solutions initiative shows enormous potential, and Fastenal’s large branch network enables it to stock and service the machines more efficiently than its competitors. Though Fastenal’s results will fluctuate with the industrial economy, its prospects for continued rapid growth in 2012 are excellent.
At the end of 2011, Advance Auto Parts (AAP) and O’Reilly Automotive (ORLY) were the fifth- and tenth-largest positions in the Fund, respectively, and together constituted 6.2% of our assets. Auto parts retail is a difficult business for all but the most efficient players. An auto parts retailer must carry literally thousands of hard parts for hundreds of models of cars. Not many people walk in the door needing an alternator for a 1994 Ford, but the person who does is probably experiencing a crisis. The retailer who can manage a substantial investment in slow-turning parts inventory is able to earn a high margin on sales.
Faced with a proliferation of parts, even commercial garages are increasingly relying on the neighborhood auto parts store to act as their local warehouse. As Americans are keeping their cars longer than before, the volume of repairs and accompanying demand for parts rises steadily.
We’ve always liked O’Reilly for its industry-leading distribution network, allowing for wide inventory coverage and prompt delivery of parts to commercial garages. The company is led by a talented and experienced team dedicated to growing the store base, expanding parts coverage, and returning excess cash to shareholders through stock buybacks. O’Reilly continues to do an excellent job integrating CSK, a Western auto parts chain it acquired in 2008. The company has a solid balance sheet and generates ample free cash flows, which should enable it to grow its store base by 3%-4% annually while sustaining stock buybacks.
We bought Advance Auto Parts in 2009 after a new management team had taken over. The company has executed an impressive turnaround since then. Looking ahead, management is focused on improving its service to commercial garages. Advance Auto Parts bought back stock worth 14% of its market capitalization in 2011 while maintaining a strong balance sheet. We think Advance can expand its store base by 3% – 4% annually and continue to buy back substantial amounts of stock.
Idexx (IDXX) performed well in 2011, generating solid revenue growth and high-teens earnings growth thanks to a slight recovery in the veterinary end market, the ramp up of its new ProCyte hematology instrument, continued share gains in reference laboratories and one-time gains from production animal disease eradication programs in Europe. While we continue to like the company’s prospects and are impressed with its execution in a still sluggish market for animal healthcare, we trimmed our position in 2011 at prices we found attractive given our expectations for the business.
As a major producer of floor coverings, the fortunes of Mohawk Industries (MKK) are tied to housing and commercial construction. In 2011, total sales for Mohawk rose about 5% as home remodeling spending grew only fitfully. For the year, commercial sales were stronger than residential. Much of Mohawk’s gains came from higher prices, as the company was able to pass along raw material cost increases. We believe Mohawk gained market share in nearly all of its product categories and geographies, thanks to new products and superior distribution. Management continued to cut costs, resulting in operating earnings that handily outpaced the increase in sales. If market conditions improve in 2012, Mohawk’s leaner cost structure should allow it to generate strong earnings leverage on sales growth.
The fiscal year of Precision Castparts (PCP) ends in March. Through the first nine months of the fiscal year, sales advanced 16% and EPS grew 18%. The company is on track to earn about $8.40 for fiscal 2012, up from $7.01 a year ago. Precision has deployed its prodigious cash flow on acquisitions. It created a new platform in aerospace structural components with the $800 million-acquisition of Primus International. In addition, it beefed up its fastener and forgings businesses with two small acquisitions and added to its technical capability in oil & gas pipes with two other acquisitions. The deal making in the oil patch paid off in September when it won a large order to supply specialty pipe to Saudi Aramco with a unique offering that allows customers to pump more oil in less time. Precision has since won an order even larger than the first. We expect more growth from Precision this year as Boeing and Airbus raise production rates. Despite last year’s activity, Precision still has more cash than debt on its balance sheet, giving it plenty of flexibility to make more acquisitions.
At Rolls-Royce (RYCEY), new CEO John Rishton had a busy and fruitful start to his tenure. Most importantly, Rishton began to focus Rolls on areas where the company stood to improve, including cash generation, cost structure and customer service. He also successfully extracted the company from its legacy narrow body civil engine joint-venture with Pratt & Whitney (IAE) for an attractive price, positioned Rolls as exclusive supplier for the Airbus A350-1000, further secured the company’s strong position on the A350 program, and closed the tricky Tognum acquisition which will begin to bear fruit in 2012. While Rolls had not released its 2011 results as of the writing of this letter, both we and the markets expect the company to report mid-to-high single digits revenue growth and low-to-mid-teens earnings growth in the year past.
The Fund made a number of new investments in 2011, adding 14 new securities to the Fund while parting with two holdings. However, none of the new purchases amounted to more than 1% of assets of year-end. Our largest investment during the year was in Corning (GLW), the glass maker. We were attracted to Corning’s dominant position in the lucrative business of supplying glass for the liquid crystal displays found in flat-screen TVs, computer monitors, and mobile phones. Only three other companies in the world are capable of producing this highly specialized glass in any volume. Unfortunately, the reality of consumer electronics is that as gadgets get cheaper every year component suppliers face constant deflation, too. As sales growth of flat-screen TVs slowed in 2011, glass manufacturers reduced inventory under severe price pressure. It also suffered from a customer defection at one of its joint ventures. Consequently, net income fell by 21%. Going forward, the company's performance will chiefly turn on its ability to moderate glass price declines. In the meantime the business is highly cash generative and management has the chance to deploy the proceeds in constructive ways such as its recently initiated stock repurchase plan.
We added to a number of our existing holdings during the year as new cash flowed into the Fund. We did not exit any significant positions during the year.
Guru Discussed: Sequoia Fund: Current Portfolio, Stock Picks
Stocks Discussed: ORL, VRX, BRK.A, BRK.B, RYCEY, IDXX, IAE, TJX, GLW, FAST, AA,