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Sydnee Gatewood
Sydnee Gatewood
Articles (3504) 

Sequoia Fund Management's Discussion of 2020 Performance

From Ruane Cunniff & Goldfarb's annual report

The total return for the Sequoia Fund in 2020 was 23.33%. This compares with the 18.40% 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 50% of Sequoia's net assets on December 31, 2020. At year-end, the Fund was 98.0% invested in common stocks and 2.0% invested in cash.

Taiwan Semiconductor's (NYSE:TSM) revenues grew 31% in 2020, outpacing the rest of the foundry industry by 5x.The company's impressive growth was driven by its continued dominance in leading edge chip production. Initially, the COVID outbreak caused management to lower revenue guidance for the year. However, the pandemic increased demands for high-performance computing, and consequently, demand for TSM's services and capacity ended the year higher than pre-pandemic levels. Adding to its 2020 tailwind, several ofTSM's largest smartphone customers stockpiled chips in connection with the trade restrictions imposed upon Huawei.

As the process for producing semiconductors has grown more complex and expensive, technology companies have increasingly outsourced production. TSM has been a great beneficiary of this trend. The company has emerged as the dominant survivor in the foundry industry, with most competitors having given up on producing at the leading edge. In fact, even Intel, whose manufacturing prowess long led the industry, has fallen behind TSM and is now considering increasing outsourced production in the coming years.

Sequoia came into 2020 with a small investment in TSM but took advantage of the volatility in the company's stock price in the spring to add to its investment below $52 per share. Despite TSM's strong performance in 2020, we believe the company's shares continue to trade at a reasonable earnings multiple as compared to our future expectations for the business.

Alphabet's (NASDAQ:GOOG)(GOOGL) revenue grew 13% in 2020, to $182 billion. The primary drivers of the company's strong growth were the usual suspects of search (+6%), YouTube advertising (+31%), and Google Cloud (+46%). During the first few months of the pandemic, a sharp spending pullback by advertisers negatively impacted search and YouTube, but as advertising activity recovered through the second half of the year, both businesses exited 2020 with excellent momentum.

Impressively, Alphabet managed to expand margins in 2020 – a year in which usage of nearly every ad-supported Google service exploded at the same time that many advertisers slashed ad budgets. Operating margins of 23% reflect a combination of outstanding operational agility and cost discipline within Alphabet's core businesses and improved operating leverage at Google Cloud. In the fourth quarter, the company disclosed operating results in its Cloud business for the first time. While we knew the business was not yet profitable, we were surprised by the magnitude of the losses today. Cloud lost over $5 billion in 2020, a figure which mostly reflected the significant fixed costs of building a global data center footprint and a product portfolio of hyperscaler quality and scope. We are pleased with the extraordinary sales momentum Google Cloud saw in 2020, a year in which Google Cloud Platform nearly tripled the size of its revenue backlog, and we believe the significant operating leverage inherent in the business model will carry margins higher as the business scales.

Alphabet entered 2020 as Sequoia's largest position. Although it declined along with the broader market in the spring, it held up better than many other companies, and as a result, its weight in Sequoia increased. In response, we trimmed our position and used the proceeds to add to existing and new investments that, in our estimation, were more attractive.Today, Alphabet's weight is nearly half what it was at the end of 2019, yet Alphabet remains our second largest holding.

UnitedHealth Group (NYSE:UNH) had a solid year despite some COVID-related volatility, with total revenues growing 6% and earnings per share growing 12%. The COVID pandemic affected UnitedHealth's operations in a couple of notable ways. First, the COVID-related spike in unemployment led to a decline in UnitedHealth's commercial covered lives; though an increase in Medicare and Medicaid lives along with healthcare inflation helped propel insurance revenues higher. Second, the company's health, prescription, and tech services business, Optum, saw a material acceleration in growth thanks to an expansion of people served in value-based care arrangements and rising home infusion services and specialty pharmacy drug spend.

Like TSM, UnitedHealth entered the year at a relatively small weight in Sequoia's portfolio. A dip in late January provided an initial opportunity to add to our investment below $290 per share, and the dramatic decline in mid-March provided another opportunity below $240 per share.Today, UnitedHealth trades at a below-market multiple of our 2021 earnings estimate, which we believe represents good value given our expectation for double digit earnings growth in the years ahead.

CarMax (NYSE:KMX) is projected to post a mid-single-digit decline in revenue during the fiscal year that ends February 2021. This decline resulted entirely from COVID-related store closures that severely hindered the company's sales first in the spring and then again in the winter. Despite these challenges, CarMax adapted to the environment well, offering curbside test-drives, remote buying and home delivery. Unlike other brick-and-mortar car retailers, CarMax didn't have to stitch together these capabilities on the fly. The company was already offering an omnichannel customer experience in many of its markets before the pandemic hit. By November, CarMax was offering omnichannel in all its markets, an important development as we believe the transition to an omnichannel offering will allow the company to thrive in the coming years. Meanwhile, the company's ability to weather the COVID storm while many traditional brick-and-mortar used car dealerships shuttered was further confirmation of CarMax's strong position.

As with several of our other holdings, we were able to take advantage of the dramatic decline in the market in mid-March by adding to our investment in CarMax at $47. We subsequently sold a portion of our increased holdings later in the year given the rapid recovery in the company's share price and its resulting large weighting in the portfolio. Despite our trim, CarMax remains a top holding.

Facebook (NASDAQ:FB) grew revenues 22% in 2020, meeting pre-COVID expectations for the year despite facing headwinds from a weak economy. Not surprisingly, in a year that saw parts of the globe locked down for extended periods, engagement with the Facebook family of apps strengthened. The relatively new areas of shopping and Reels short videos are gaining traction. Growth in ad revenues increased in Q4, largely driven by the acceleration of e-commerce, and sales are booming at Facebook Reality Labs, the division that produces virtual reality headsets. While Facebook turned in strong financial performance in a difficult environment, 2020 was not without turmoil as political discourse raged on the company's apps. As part of its year-end earnings announcement, management indicated that it intends to deemphasize political content in the newsfeed. In our view, regulation remains a significant risk for the company. That said, we believe this risk is reflected in the shares with Facebook trading for ~24x consensus forward earnings, a near market multiple for a dominant social media enterprise whose earnings we expect to grow far in excess of the overall economy for years to come.

Arista Networks (NYSE:ANET) is projected to report a year-over-year decline in revenues in 2020, largely caused by a pullback in infrastructure spending at Facebook and Microsoft, Arista's two largest customers in the early part of the year. However, the company returned to growth in the fourth quarter, and customer spending patterns suggest Arista is poised to grow at a healthy pace in 2021 and beyond. Notably, we believe Arista is well positioned to benefit from a coming upgrade cycle, which is expected to see many cloud network providers replace their existing switch hardware with the latest 400G high-speed switches. Importantly,Arista's 400G product lineup has been well received, with our research suggesting the company is defending its leading market position in high-speed switches successfully. We continue to believe that Arista's unique software-first approach to design and quality assurance together with its supremely talented management allow it to create superior products.

Arista's shares appreciated rapidly as fears over weak demand from its top customers abated in the latter part of the year. We recently trimmed the position as the business's valuation grew more challenging, but Arista remains a holding in the portfolio given its inherent advantages and market tailwinds.

Credit Acceptance (NASDAQ:CACC) had a solid year despite the pandemic. Total revenues rose 12% and adjusted net earnings rose 4%. Due in part to a hefty share repurchase, earnings per share grew 10%. Unit loan volume declined 8% during the year, driven by dealer closures, inventory challenges, a more discerning underwriting approach and a decision to deploy more capital towards repurchasing shares at attractive prices rather than making loans at lower returns.

Credit Acceptance falls under the purview of a number of regulatory bodies, including attorneys general offices in all states in which it operates, the Consumer Financial Protection Bureau, and the Department of Justice. Late in the summer, the Massachusetts attorney general announced a lawsuit alleging that Credit Acceptance violated consumer lending laws. Our research on these claims has led us to believe that they are overstated, and while we believe the resolution of Credit Acceptance's regulatory issues could involve material costs, the current valuation discounts a conservative estimation of these risks. We feel the company is likely to perform well in the coming years, and we have opportunistically added to our holdings.

Eurofins Scientific (XPAR:ERF) had a strong 2020 as continued performance by its core business was enhanced by a boost from COVID testing. Revenues grew 18% for the year, driven largely by organic growth as the company shifted its attention away from M&A and towards COVID-related efforts, integrating prior acquisitions, and finalizing some infrastructure and operational initiatives. Despite the shares' strong performance during the year and our expectation for COVID testing tailwinds to abate in the years ahead as vaccination programs and other measures bring the pandemic under control, we remain optimistic about the company's growth prospects under its talented management team.

Constellation Software (TSX:CSU) experienced a deceleration in growth in the second quarter as customers put off license purchases and acquisition activity slowed, but the business saw a quick rebound by the next quarter. Constellation enjoys a very steady base of business because it provides mission-critical solutions and derives most of its revenue from recurring maintenance sales. Over the course of the year, the team learned how to make acquisitions remotely and the company continues to deploy significant capital at attractive rates of return.

In May, Constellation'sTotal Specific Solutions (TSS) unit reached a deal to merge with Topicus.com BV, another large Dutch software vendor with a unique approach to organic growth. TSS was itself acquired by Constellation in 2013, shortly before we invested. The combined TSS-Topicus entity spun out into a separately listed company in the first quarter of 2021.

Costellation's shares trade for a healthy 30x multiple of our estimate of the company's forward cash earnings per share. And while we acknowledge that this is a premium valuation, we also believe that this is an exceptional company led by a terrific team with plenty of arrows in its quiver.

The Walt Disney Co. (NYSE:DIS) was added to the portfolio in June when the stock was depressed due to concerns about how COVID would affect the company's Parks business. Though Parks is certain to be unprofitable for the near future, we believed the stock market was overreacting given the segment only represents about 25% of the company's normalized operating income. We expect Parks to rebound quickly when leisure travel resumes.

Meanwhile, we have been following Disney for some time and were impressed by management's clear commitment to streaming with the launch of Disney+ in late 2019. The combination of an iconic content library and a world stuck at home due to the pandemic helped Disney+ reach 60 million subscribers in just nine months, a target it had originally set for 2024. Capitalizing on its early momentum, Disney has reorganized its divisions to be streaming-first, upped its financial investment in streaming, and laid out an ambitious goal of roughly 245 million Disney+ subscribers by 2024. It is still early days for streaming, but we believe Disney's unparalleled franchises should position it to be one of the dominant players as the streaming market naturally consolidates.

Disney rallied during Q4 as the market began to appreciate the size of the streaming opportunity. Today, the stock trades at 27x our estimate of underlying 2021 earnings, already nearly 50% higher than where we purchased our shares in June, but still a fair valuation for a company that we expect to compound earnings at a double-digit rate annually for the next decade.


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