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Holly LaFon
Holly LaFon
Articles (9202)  | Author's Website |

Sequoia Fund Management’s Discussion of Fund Performance

From Ruane Cunniff

The total return for the Sequoia Fund was 20.07% in 2017. This compares with the 21.83% 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 table below shows the 12-month stock total return for the top ten equity positions at the end of 2017.

The underperformance of the portfolio vs. the S&P 500 in 2017 was largely driven by the portfolio’s cash position, which averaged about 9% during the year. The equity portfolio of the Fund generated a 23.6% gross internal rate of return in 2017. The ten equity holdings listed above constituted about 63% of Sequoia’s assets under management on December 31, 2017. At year-end, the Fund was 95% invested in common stocks and 5% invested in US Treasury Bills and cash.

Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) posted a second straight year of flattish look-through earnings, as earnings comparisons were affected by higher-than-normal catastrophe losses and the redemption of $10 billion worth of high-yield preferred shares issued around the time of the financial crisis by Wrigley, Dow and Bank of America. Book value received a strong boost from the new tax law, which meaningfully reduced the deferred tax liability, and investments per share grew strongly due to a 20%+ increase in the insurance float and strong price appreciation by several of Berkshire’s larger stock holdings, including Apple, Bank of America and American Express. In October, Berkshire agreed to buy 80% of the largest truck stop operator in the US, Pilot Flying J.The two-step nature of the deal— the second step will take place in 2023— means that the deal will not make a meaningful dent in the company’s cash hoard, which was over $109 billion at the end of the third quarter. The largest opportunity to build intrinsic value would come from an acquisition that uses up most of this cash.The current frothy market environment presents a challenge for putting large sums to work at good returns. However, Berkshire is, as always, well positioned to take advantage of the next market disruption.

Alphabet (NASDAQ:GOOG) continued to grow at a blistering pace in 2017, remarkable for a company of Alphabet’s size. Revenue rose 23% over the prior year, while operating income before exceptional items rose by 22%.This growth was largely driven by a continuing shift to mobile search, a phenomenon which has proven to be highly accretive to Alphabet’s financial results over the past several years. YouTube viewership growth was another highlight of 2017, outpacing the company’s overall growth rate.

Over the past five years, Alphabet has grown its core earnings more than four times faster than the average S&P 500 company, and the tailwinds driving that growth remain in place today. In light of the company’s rapid growth, dominant position, and exceptional management, we believe Alphabet merits a large valuation premium to the S&P 500 Index. Yet after accounting for excess cash and startup losses, we find that Alphabet garnered a very modest premium to the index for most of the year. At the end of the third quarter, we added to our already substantial position in Alphabet at a price of $921 per share, making it the second largest holding in Sequoia’s portfolio behind Berkshire Hathaway. We believe our purchase price amounted to less than 20x expected core earnings in 2018, a clear bargain for one of the world’s best businesses.

With great success comes great scrutiny. The European Competition Commission levied a €2.42 billion fine against Alphabet in the third quarter of 2017 for allegedly promoting its own price comparison service over those of competitors. The company is appealing the fine and the amount is manageable for a company of Alphabet’s size – it amounts to about nine days of revenue. However, we perceive a rising tide of antitrust sentiment among both regulators and the public globally. We expect the regulatory environment to grow more difficult for Alphabet and its mega-cap technology peers as time passes. We consider this a natural consequence of the company’s dominant worldwide position. We do not believe it constitutes a serious threat to the health of the business, which continues to provide immeasurable value to consumers, gratis.

Mastercard (NYSE:MA) produced yet another strong set of financial results in 2017 with top line and earnings per share growth up by mid-teens for the year.The company’s business model remains very attractive, with powerful trends driving ever-increasing adoption of the electronic payments that Mastercard enables. We believe Mastercard’s competitive position remains very promising over the short to intermediate term. Longer term, we are trying to keep our antennae attuned to potentially disruptive technological threats. Meanwhile, Mastercard’s many virtues are as well appreciated as ever by the stock market and the company’s valuation feels both full and fair.

Constellation Software (NYSE:CSU) delivered solid performance again in 2017. Revenue grew in the mid-teens with a low single-digit organic contribution and margins remained strong, leading to mid-teens growth in earnings. The company took an important step last year, expanding the M&A team under CIO Bernie Anzarouth to accelerate its rate of acquisitions. This investment appears to be bearing fruit. In the first nine months of 2017, the company deployed more on acquisitions than it did in the full year 2016. This pace is not enough to soak up all of the company’s cash flow, but it is a remarkable achievement against a tough backdrop. Asset prices are up, debt is inexpensive and Constellation’s success has attracted copycats.This is one of the most financially disciplined companies we have ever come across, so to see it find investments in this environment bodes well for when markets inevitably turn.

Dentsply Sirona (NASDAQ:XRAY) had a frustratingly eventful year. Although full-year profits are expected to be down only modestly, the company’s decision to open up its historically exclusive distribution setup in its US equipment business, however wise, resulted in massive short-term disruption. This disruption was at least partly responsible for the $1.2 billion non-cash impairment charge it took in the second quarter. In October, Dentsply Sirona announced that CEO Jeff Slovin and executive chairman Bret Wise had both tendered their resignations. Mark Thierer, a respected executive in the pharmacy benefit management space, was named as interim CEO. In January, Dentsply Sirona announced that Don Casey, formerly of Cardinal Health and Johnson & Johnson, would become its permanent CEO. On top of all this, growth in the global dental market was anemic this past year.

Dentsply Sirona still has a very high quality business, both in terms of profitability and durability. The relative stability of the business through the events of this past year is a testament to this fact. However, the lack of management stability is an unqualified negative. We will be monitoring the situation closely.

TJX (NYSE:TJX) generated weak stock performance and middling earnings growth as the company wrestled with higher entry level wages and the continuing adverse impact of foreign currency translation on earnings sourced outside the United States. Over the past few years, TJX has generated solid growth in store traffic and sales, but the company has struggled to convert that into satisfactory earnings growth.

Looking forward,TJX ought to be a major beneficiary of tax reform, as the company generates more than $3 billion of operating profit in the US. As the US corporate tax rate moves from 35% to 21%, TJX could generate more than $400 million of incremental net income from tax relief. Some of this no doubt will be reinvested in the business or passed on to consumers, but we would note that TJX is far more profitable than most apparel retailers. This means it receives greater tax savings, both in percentage and absolute terms. Under the old tax regime, TJX generated outstanding margins and returns on capital, while offering great value to consumers. Thus, we see the company potentially keeping most of the tax savings, which could boost earnings per share in 2018 by about 15%. Recently, the euro, British pound and Canadian dollar have all strengthened considerably versus the dollar. If these gains hold, TJX would get an added lift to 2018 earnings. We are comfortable that TJX will continue to deliver outstanding value to shoppers and we expect tax reform to end up benefiting the strongest US retailers and accelerating the demise of less profitable stores.

Rolls Royce began to emerge from its recent difficulties in 2017. The company’s Civil Aerospace business continues to go through a period of profit pressures as it rapidly scales the number of loss-making new engines it is delivering into the market (which will generate long-lived aftermarket profits in the future). But Rolls has so far been able to successfully manage its production and delivery ramp up.There is more work to be done around improving the economics of these new engines as the programs scale but we see increasing evidence that OE losses will decline and aftermarket driven profit improvements will flow through the business in the years ahead.

Management has also done an admirable job of simultaneously tackling Rolls’ bloated cost structure, tightening the company’s focus and bringing in fresh talent. The company recently announced a “strategic review” of its commercial marine business, which will likely lead to its eventual sale. We have long believed that the commercial marine business does not benefit from being a part of the larger Rolls-Royce organization because of its very different end market characteristics.

Rolls-Royce has not yet reported its full year 2017 results, but we expect results to begin to reflect the improvements discussed above, with overall revenue and profit up slightly on a constant currency basis. Importantly, because new accounting rules call for the delayed recognition of aftermarket revenue and profit, Rolls’ results will understate its cash profitability during periods in which it is rapidly growing its installed base of engines – as is currently the case. As a result, we expect cash earnings to be higher than and grow faster than reported profits over the medium term.

Charles Schwab (NYSE:SCHW) had an excellent year. The company’s diluted earnings per share rose 23%, driven primarily by a 21% increase in client assets as well as a modest increase in interest rates, which favorably impacted the spread the company earns on the client cash it keeps at its internal bank. A strong stock market contributed to the growth in client assets, but so too did Schwab’s continued asset gathering. The company took in nearly $200 billion of core net new assets, up 58% from 2016.These net new assets alone contributed seven points to the company’s growth in client assets.

Schwab’s investor-friendly strategy positions it well to continue gathering assets from the traditional wirehouses that still hold client assets on the order of $10 trillion. Moreover, the trend towards passive investment products and automated investment advice represents more opportunity than risk for the company. We believe that Schwab has a powerful value proposition that is supported by long-term secular trends and that the stock should generate, from here, a good through-cycle return.

Carmax (NYSE:KMX), the country’s largest retailer of used cars, had a good year with strong performance from both new and existing stores. Sales rose about 9% and EPS grew about the same. The top-line growth should have translated into even more earnings growth but did not because Carmax has been investing heavily in technology. It is determined to preserve its spot as the most consumer-friendly option for buying a used car. To that end, it undertook a dizzying array of digital initiatives that included revamping its website, improving its search engine marketing and improving the image quality of the cars it shows online. It also launched online pre-approvals for financing and conducted a test for home delivery. This year, we expect to see the roll out of online ordering and the benefits of a dramatically improved customer retention management system that will give Carmax easily accessible information on its customers. Carmax opened 16 stores during the year, taking the total up to 185. It could ultimately have as many as 300, with the most opportunity coming in small stores located closer to customers. Carmax’s financing business also performed well in 2017. Given that it only lends to prime customers, we expect that it should be able to preserve its financing spread as interest rates rise.

We participated in Liberty Media’s private placement of shares to a select group of investors in early 2017 that helped the company close its acquisition of Formula One, the world’s leading motorsport with over 400 million active fans. We believe Formula One is a powerful global brand and Liberty will be an excellent manager. The new management team under CEO Chase Carey has significant opportunities to improve and grow the sport. Specifically, we believe there is room to improve revenue from both broadcasters and sponsors, while also developing a digital business that captures younger fans.

Management spent most of 2017 building out core functional groups and investing for future growth, particularly in efforts to improve the quality of races and to build out a digital offering. Given these higher levels of investment, we don’t expect strong initial earnings growth. But we do believe these investments have laid the groundwork to drive both top line and bottom line growth in the years ahead. Longer-term, Formula One also started negotiations with teams about spending caps and a more equitable allocation of funds across teams post expiration of the current agreement in 2020. We expect these negotiations to take some time with plenty of noise in the press in the months ahead from various participants. But we are encouraged by the start of talks and the direction Liberty wants to take the sport in the years ahead.

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About the author:

Holly LaFon
I'm a financial journalist with a master of science in journalism from Medill at Northwestern University.

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