There are three gurus who are suffering tremendously through big concentrated bets on Valeant (VRX, Financial) that backfired starting at the end of last year.
The Sequoia Fund is taking perhaps the worst of it. With a 30%-plus position, it had two directors resign over the concentrated bet last year. In response, instead of cutting back, Sequoia upped its stake while the share price was falling due to the controversy surrounding the Philidor pharmacy.
If you have followed the Valeant story, you know that things turned for the worse this year with the company coming out with strings of bad news and postponing its next 10-K. Meanwhile, CEO J. Michael Pearson got ill, returned to the company and has now left. Sequoia is likely under tremendous pressure from investors as it put out a letter on March 23 dealing with the issue and announcing the retirement of Bob Goldfarb:
Dear Shareholder,
After an extraordinary 45-year career in investing, Bob Goldfarb, our chief executive officer and Sequoia Fund co-manager, is retiring. David Poppe, who has served as the co-manager of Sequoia for the past 10 years alongside Bob, will replace him as Ruane, Cunniff & Goldfarb’s CEO and will now serve as the lead manager of Sequoia as part of an investment process that will showcase the talents of one of the best research teams in our industry. The board of Sequoia Fund fully supports these changes. A uniquely brilliant student of business, Bob played an important and valued role in producing the outstanding long-term investing record of which we now become the stewards.
It looks like Goldfarb is taking responsibility and stepping down over the Valeant investment. It is probably necessary to have a scapegoat sacrificed over this to keep investors happy. On the other hand when CEOs or portfolio managers have to step down because they run a concentrated portfolio (a strategy that is clearly communicated) and the top position goes awry, that's a terrible signal to send portfolio managers.
Just look at the top 10 holdings view, and you will quickly see how many gurus (the absolute best of the best in money management) run with concentrated portfolios. If running a concentrated book introduces a lot of career risk even though it also produces the most alpha, that's a bad thing. Managers lose their incentive to produce alpha.
Over 45 years through the end of 2015, Sequoia Fund has returned 14.0% per annum versus 10.8% for the Standard & Poor's 500 index, with $10,000 invested at Sequoia’s inception worth $3.9 million versus $1.0 million for the same amount invested in the index. Over the last 20 years, we have returned 10.2% per annum versus 8.2% per annum for the index. Perhaps most meaningfully, over the 36 rolling 10-year periods since inception, Sequoia has only underperformed the index twice — for the decade ended 1994 and the decade ended 1999. We owe these achievements to immense talents like Bill Ruane, Rick Cunniff and Bob Goldfarb, but we believe we owe our success first and foremost to a simple but powerful strategy: The careful selection of a focused portfolio comprised of intensively researched investments, purchased with a margin of safety.
If you are a skeptic this is where you ask, "Where is that margin of safety at Valeant?" I don't know, but it isn't out of the ordinary for value managers to misjudge a margin of safety. It's just unfortunate if you do it with a stock you have backed up the truck on.
While we have beaten the market over the past decade, through the end of 2015, our investment in Valeant has diminished a record that we have built over two generations and in which we take great pride. We are a loyal, dedicated and intensely driven group, and to the extent that we have lost any of our investors’ confidence, we are determined to win it back.
Sequoia only beat the market by an extremely slim margin over the past decade but to be fair it was a rare but terrible decade for value investors. I expect it will be awhile before Sequoia wins investors back.
While our commitment to a value-oriented strategy grounded in extensive primary research remains as strong as ever, the Valeant experience has spurred a period of reflection. Going forward, we have resolved to take a more collaborative approach to constructing the portfolio that will feature a more significant role for our senior analysts, including Greg Alexander, Jonathan Brandt, Arman Gokgol-Kline, John Harris, Trevor Magyar, Terence Paré, David Poppe, Chase Sheridan and Greg Steinmetz. Our team boasts a combined tenure at Ruane Cunniff (Trades, Portfolio) of more than 125 years, and several members have successfully managed significant sums of client capital for more than a combined 50 years.
Star managers' track records are often attributed almost completely to their extraordinary skills but in fact these star managers often do not reproduce the same results when they switch teams. Bill Gross comes to mind as a prominent example even though he deserves more time at Janus.
The same is true the other way around. If a manager with a terrible track record is leaving (which is not the case here), the team isn't suddenly going to improve a lot. The new approach is not likely to improve performance. However, the truly long-term performance (which is excellent) should be attributed to the culture of the organization and the team as much as the star managers.
As we have noted many times over our history, it is inevitable that, from time to time, our concentrated approach to portfolio construction will cause us to diverge from the market averages. In 1999, Sequoia underperformed the S&P index by 37 percentage points. Over 1972 and 1973, we underperformed by 23 percentage points. Though past performance is obviously no guarantee of future results, and though different factors admittedly drove each of these rough patches, we have every expectation that we will recover from this one by staying focused on our core principles of outstanding investment research, thoughtful security selection and stringent price discipline.
This paragraph will sound hollow to shareholders, but there is actually so much truth to it. Fund investors underestimate how badly even the best of the best in money management will underperform at times. Even Warren Buffett, arguably the best investor of all time, underperformed the S&P 500 over the past five years.
We are grateful for your patience during a disappointing period. We are profoundly fortunate to have attracted over the years a client and shareholder base possessed of a uniquely long-term perspective that aligns with our own. We realize we have a special relationship with our investors that is unusual in the investment industry. We have earned it by delivering strong investment results over a long period, and we are confident that we will continue to prove ourselves worthy of it in the future. We think often about our founders, Bill Ruane and Rick Cunniff — their values, their achievements and their legacy. The challenge of living up to the example they set for us is a constant one that we embrace, and as we take it up under the next generation of our firm’s leadership, we find ourselves energized. If you have any questions, please call our director of Client Services, Jonathan D. Gross at 212-832-5280.
Sincerely, David M. Poppe and the Ruane, Cunniff & Goldfarb Team
So is this a good or a bad time to invest in the Sequoia Fund? With Morningstar just putting its Analyst Rating under review, it's a decision that's harder to make. Often strong outflows follow after a fund underperforms badly and inflows follow after a winning streak. Performance unfortunately tends to revert to the mean, and investors end up achieving worse results than the fund itself by timing their entry and exit points. Recent performance is a terrible counselor. Instead, I'd ask myself if I want to invest in a strategy that's described as a:
careful selection of a focused portfolio comprised of intensively researched investments, purchased with a margin of safety.
Then I'd ask myself if I would be satisfied with a slight outperformance over the truly long term and if I'm willing to accept bouts of strong volatility in order to get there. If my answer is yes, the Sequoia Fund continues to be a great option.
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