The Sequoia Fund is one of the most successful and storied value funds there is. Ruane, Cunniff & Goldfarb L.P. have managed the mutual fund since its inception on July 15, 1970, and during that time, it has produced enormous returns for investors. Since its inception, the fund has returned 13.42% per annum average compared to a 10.86% return for the S&P 500.
Since its inception, the fund has navigated many market environments. It has also suffered some significant losses. Nevertheless, the investment manager was founded on some solid investment principles that remain true to this day.
In 1980, Ruane, Cunniff & Goldfarb L.P. (which included Bill Ruane, one of the original super investors of Graham and Doddsville) outlined its investment philosophy and principles in a note for clients.
While this document is now nearly 40 years old, it still contains plenty of investment advice relevant even in the current market environment.
The overwhelming goal of the fund in 1980 was to buy high-quality companies trading at a discount to their intrinsic value. In searching for undervalued securities, Ruane, Cunniff & Goldfarb L.P. were on the lookout for four factors.
The most important of these was that the company was a "good business." According to the 1980 document, the single most crucial indicator of whether or not a company was a good business was its return on capital.
"We believe that in almost every case in which a company earns a superior return on capital over a long period of time is because it enjoys a unique proprietary position in its industry or has an outstanding management," the note declared.
The second factor on the list was to "buy businesses with pricing flexibility." This was based on the assumption that inflation would be the most significant risk investors faced in the near term. In fact, at the time, Ruane, Cunniff & Goldfarb predicted that inflation could be as high as 7%. As such, it was vital for investors to own companies that had pricing flexibility, according to the note.
The third criterion on the list, and for me probably the most important, was the firm's instance only to buy "net cash generators." As the note explained:
"We think it is important to distinguish between reported earnings and cash earnings. We have found that in a period of rapid inflation, many companies must use a substantial portion of earnings for forced reinvestment in the business merely to maintain plant and equipment and present earning power. Because of such under-depreciation, the reported earnings of these capital-intensive companies may vastly overstate their true cash earnings. Cash earnings are those earnings which are truly available for investment in additional earning assets, or for payment to stockholders. We have emphasized companies which have the ability to generate a large portion of their earnings in cash."
The fourth and final point in the update was to "buy stocks at modest prices." It explained that while it is impossible to eliminate price risk altogether, it is possible to substantially reduce this risk by avoiding "high multiple stocks."
Four simple principles
This guide from Sequoia is hardly long or challenging to understand. However, the four simple principles contained within are highly informative and could help any investor dramatically improve their investment process.
That's why I think Sequoia's document from 1980 is so informative. It presents a simple framework for finding good quality companies at attractive prices that any investor can follow, no matter how much or little experience they have.
Forty years on, the lessons are just as relevant as they were when they were first published in August 1980.
Disclosure: The author owns no share mentioned.
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