The total return for the Sequoia Fund in 2019 was 29.12%. This compares with the 31.49% return of the S&P 500 Index.
Our preference 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 top ten equity positions constituted approximately 59% of Sequoia’s net assets on December 31, 2019. At year-end, the Fund was 98.6% invested in common stocks and 1.4% invested in cash.
Alphabet’s (GOOG, Financial)(GOOGL, Financial) revenue grew 18.3% in 2019, to $162 billion. The primary drivers of Alphabet’s remarkable growth were once again mobile search, YouTube and Google Cloud Services. In a first, Alphabet disclosed revenue figures for YouTube and Google Cloud in the company’s fiscal 2019 financial report. YouTube generated $15.1 billion in revenue in 2019, up 36% over 2018. Google Cloud generated $8.9 billion in 2019, a 53% improvement over 2018. Google Cloud’s growth looks set to continue; the company disclosed an order backlog of $11.4 billion.
Growth at such a rapid pace for a company of Alphabet’s scale is hard to comprehend and even harder to sustain. Search advertising revenue is Alphabet’s most mature business and its biggest economic engine by far, and it grew 15% year over year.That is nothing short of heroic for a twenty-year-old business segment generating roughly $100 billion of annual revenue.
The rapid growth of younger business segments that remain in their investment phase has naturally pressured Alphabet’s operating margin over the past several years, causing revenue to outpace operating income. 2019 was no exception to this trend. We estimate Alphabet’s operating profit after taxes grew 13% in 2019, after certain adjustments that filter out noise in the reported figures.The wisdom of trading operating margin for revenue growth will be determined by the long-term return on Alphabet’s myriad current investments, and for many of these it will be years before the results are in. Google Cloud in particular will require significant investment as Google battles Amazon Web Services (“AWS”) and Microsoft Azure for its share of the cloud computing services market. It is worth noting that AWS achieved an operating margin nearly equal to Alphabet’s current operating margin when it was about the size of the current Google Cloud business. We are hopeful that Google Cloud will generate a healthy and expanding margin as the size of the business increases.
In the fourth quarter, Alphabet announced that founders Larry Page and Sergey Brin would step back from their respective roles as Alphabet’s CEO and President. Sundar Pichai, already CEO of Google, Alphabet’s most important business, will take over as CEO of parent company Alphabet and assume responsibility for the company’s Other Bets in addition to his previous responsibilities. It will be interesting to see how Alphabet’s “moonshot” projects, collected under the banner of Other Bets, will develop under Pichai’s leadership. While Alphabet’s many non-advertising initiatives help the company attract and retain talent, and a few of them have the potential to grow into sizeable businesses in the long term, we believe there is scope to improve Alphabet’s focus when it comes to the allocation of resources to Other Bets.
This coming June will mark the ten-year anniversary of our investment in Alphabet. As we write this, the investment has returned 20% annually, a remarkable result given that Alphabet enjoyed a market capitalization exceeding $150 billion at the time of our investment.This record is a credit to the company and a testament to the remarkable power of Alphabet’s business and that of dominant internet platforms generally. Our appreciation of the unusual ability of these platforms to generate durable growth at enormous scale has informed our subsequent investments in Amazon, Facebook and Wayfair, all of which are market leaders in their respective niches.
With great power comes great responsibility. It is clear that certain scaled internet-based platforms, including Alphabet’s YouTube video platform, possess the wherewithal to shape the cultural landscape in profound and often unpredictable ways.To monitor the body of user-generated content onYouTube requires an enormous investment in people and technology, and it is little wonder that YouTube and other social platforms prefer to be characterized as neutral distributors of third-party content rather than as publishers, given that the latter designation carries the implication of editorial control and its attendant obligations. Over time, cultural and political developments have rendered a laissez-faire approach to content distribution increasingly untenable, leadingYouTube and its peers to invest significant sums to improve the security and monitoring of their platforms. It is a certainty that billions of dollars of further investment will be required, but taming problematic content is a profoundly important goal from both a societal and a business standpoint. Progress in this area will make the dominant social platforms more sustainable, more trusted, and harder to disrupt.
In light of the substantial increase in the company’s valuation in 2019, we modestly reduced the size of our Alphabet position. However, Alphabet remains a compelling business with an attractive valuation, and it remains the largest position in the Sequoia portfolio.
Berkshire (BRK.A, Financial)(BRK.B, Financial) had a quiet year with aggregate earnings likely up about 5%. Deploying cash at attractive valuations was challenging because of a strong stock market fueled in part by a decline in interest rates. Berkshire did manage to negotiate the purchase of $10 billion of Occidental Petroleum preferred stock, which pays an attractive 8% dividend and comes with $5 billion of warrants attached. Some existing holdings experienced challenges, including Kraft (competition from private label), GEICO (competition from Progressive), Wells Fargo (continued fallout from the phantom account scandal) and the BNSF railroad (competition from trucks, bad weather, tariffs, and low natural gas prices). We were encouraged to see leadership changes at three of the four above named companies, and a fourth is probably in the offing. On the plus side, Berkshire’s largest public holding, Apple, has seen its stock price more than double during the year as profit trends stabilized on the back of strong sales of AirPods and other wearables. (The value of Berkshire’s stake in Apple today is worth as much as all of Berkshire traded for 20 years ago.) Berkshire continues to sell at a meaningful valuation discount to other stocks after backing out a cash hoard equal to 25% of the company’s market cap.
Carmax (KMX, Financial) posted 10% revenue growth, fueled by sixteen new stores and solid same-store sales growth. Helped along by aggressive share repurchase and a lower tax rate, earnings rose 19%. Carmax believes the future of used car retailing belongs to omni channel retailers like itself that can sell cars at stores and online. Carmax took several steps to transition to the omni model last year. It replaced hundreds of commissioned salespeople with customer experience managers who, working from four regional locations, handle orders and questions from customers. It reduced the arduous paperwork involved in car buying by moving to electronic documents and e-signatures. It expanded home delivery to half its markets, and began offering online pre-approvals for loans and online appraisals on trade-ins. Although Carmax’s development of omni channel represents the biggest makeover in the company’s history, it has so far managed the transition without diminishing margins. We believe many competitors will struggle to keep up and that omni increases the size of Carmax’s competitive moat.
Mastercard (MA, Financial) reported a strong result in 2019. Net revenue grew 16% on a currency-neutral basis. With operating leverage, a lower tax rate and share buybacks, diluted earnings per share grew 23% on a currency-neutral basis. We continue to believe the longstanding secular tailwinds for Mastercard remain intact.At the same time, we continue to monitor potential technological threats as well as regulatory and legal developments in various geographies. Taken altogether, we believe Mastercard’s current valuation is fair for a superior business with a history of positive surprises. We nonetheless trimmed our position during the year as the stock price outpaced our estimate of growth in intrinsic value.
Constellation Software (TSX:CSU, Financial) continues to scour the world for niche software companies, finding acquisitions in new verticals like crash/crime scene diagramming and new geographies like Brazil. The company has done a remarkable job scaling its acquisition strategy, but management realizes that to sop up its growing cash flows it will need to find new arenas to deploy capital. One such arena is larger acquisitions, where Constellation faces more competing bids from private equity firms and strategic buyers. In 2019, Constellation’s board approved a lower yet still attractive return hurdle for large acquisitions in order to participate more in this market. We look forward to seeing if this effort proves fruitful in 2020.
When we originally bought shares of Constellation, the rest of the market had not assigned them much value for continued growth by purchasing yet more vertical software companies. Over time, the company’s ability to make superior rates of return on these acquisitions seems to have become well-appreciated as the market has assigned higher and higher valuations to the stock.
At times, the shares in our estimation have traded too dearly unless the company can somehow shift acquisitions to an even higher gear. Management has signaled the difficulty of allocating ever-larger incoming cash flows while maintaining strict valuation discipline, most pointedly with a $20 special dividend issued in the first half of 2019.Though our preference is to take the full journey with this exceptional team, we have from time to time sold some shares to buyers with more exuberant expectations.
Credit Acceptance (CACC, Financial) had an outstanding year. Sales rose 16% and operating earnings rose 30%. Earnings per share grew 22%, held back by a return to a normal tax rate after an unusually low rate the prior year. The market for subprime auto loans remains highly competitive. Despite that, the company’s underwriting discipline remains strong. A change in accounting rules will sharply curtail the company’s GAAP earnings in the coming year, but the change in accounting optics has no bearing on the economics of the business. Market concerns about how car loans will perform in a recession kept Credit Acceptance’s valuation at an attractive level for most of 2019. Because Credit Acceptance has a disciplined and differentiated approach to underwriting loans, we believe it would continue to thrive in a recessionary environment and may well grow market share as competitors struggle with losses.
Jacobs Engineering Group (J, Financial), a professional services firm, turned in strong performance for the fiscal year. It grew revenues 11% organically and grew diluted earnings per share roughly 15%. When CEO Steve Demetriou joined in 2015, he laid out a back-to-basics strategy of eschewing commoditized, risky projects in favor of high-margin, predictable business. Management has been hard at work realizing this vision and the company whizzed past several milestones in 2019. It divested its Energy, Chemicals & Resources division at an attractive price, freeing the company of its least profitable and most cyclical segment. Management used the proceeds to expand Jacobs’ portfolio in the attractive government services space with the acquisitions of KeyW and Wood Group’s Nuclear business. Further, nearly two years after the transformative acquisition of CH2M, it is safe to say the integration has been a success. The company celebrated in November with a rebranding from “Jacobs Engineering” to “Jacobs Solutions,” a well-deserved recognition that Jacobs is now a low risk, capital-light solutions provider serving attractive end-markets.
Charter Communications (CHTR), which we own via Liberty Broadband (LBRDA), demonstrated how the slow-and-steady world of cable internet can still produce stellar results. We estimate revenue only grew 3% in 2019 as the steady bleed of low-margin video subscribers continued. However, cash operating profit grew 45% on continued broadband growth and declining capital expenditures.That, combined with Charter’s disciplined practice of returning capital via share buybacks, meant free cash flow per share grew over 75% in 2019. We are pleased with the performance, but we do not expect such eye-popping growth going forward. Capital expenditures had been elevated due to merger integrations and an extensive network upgrade. With these investments complete, future margin improvements should be more incremental. That said, overall profit growth should be more than satisfactory. Internet has become an everyday utility of growing importance and Charter’s broadband offering should continue to take share from AT&T and Verizon.
Formula One (FWONA) Management announced in October 2019 that all 10 participating teams had unanimously approved the sport’s new Sporting, Technical and Commercial Regulations. As we mentioned in last year’s letter, given the practical realities of implementing a new successor Concord Agreement in 2021, Formula One needed to secure at least high-level agreement on the key elements of a new governing deal in 2019. There are five parts to the Concord Agreement: Sporting, Technical, Commercial, Financial and Governing Regulations.The Sporting, Technical and Commercial regulations needed to be confirmed about 18 months ahead of implementation to allow for the teams and league to make necessary changes ahead of expiration of the current agreements at the end of the 2020 season.
We are encouraged by the progress achieved during the 2019 negotiations. As part of the new Sporting, Technical and Commercial Regulations, the league made important strides toward enhancing the competitiveness of the sport, which should bolster fan engagement. Most importantly, as part of the new Commercial Regulations, the sport will adopt a new cost cap starting in the 2021 season that should reduce the spending gap separating the top teams and the middle of the field. In addition, the new Technical Regulations increase the sharing of intellectual property and improve the ability of cars to pass one another on the track, a key aspect of exciting racing.There are still some important components to be worked out, including profit splits between the teams and the league itself, as well as Governance Regulations that hopefully reduce the power of the leading teams to stifle rule changes that improve competition.
Financially, a new broadcast contract in the UK helped drive revenue and profit growth in 2019. We expect revenue and profits to continue to advance in 2020, thanks to new sponsorship and advertising contracts that will take effect, as well as the addition of one new race to the calendar, bringing the total to 22.
Facebook (FB, Financial) grew revenues 27% in 2019. Despite unrelenting bad publicity, much of it warranted, engagement with the Facebook family of apps remains healthy. Instagram continues to attract new users across the world. The popularity of the "Stories“ format and the introduction of shopping in the app should contribute to years of rapid growth. The average time spent in the ”Blue“ Facebook app stabilized during the year. Facebook’s efforts to emphasize meaningful social interactions rather than passive media consumption are bearing fruit and should enhance the durability of the social network. While regulation remains a risk for the company, at ~25x our estimated earnings power, Facebook remains one of the cheapest high-growth companies we follow.
