Up until 2014, the Sequoia Fund was one of the most respected investment managers on Wall Street.
Sequoia can trace its history back to the early 1970s, when its founders, led by Bill Ruane, set up the fund at the request of Warren Buffett (Trades, Portfolio), who was liquidating his original investment partnerships. Buffett asked Ruane, who he greatly respected as an investor, to set up the fund to take over the management of money for his partners who didn't want to take their capital out of the market.
Over the next several decades, Sequoia carved a reputation for itself as a rational investor that only acquired high-quality companies trading at discounted prices and had a long-term holding period.
Even after the financial crisis, when so many active managers struggled to beat the ever-rising S&P 500, Sequoia continued to stand out as one of the best asset managers around. In 2014, the fund boasted a five-year annualized return of 17.8% versus 15.5% for the S&P 500 index and a 10-year annualized return of 9.2% versus 7.7% for the index.
But then, in 2015, Sequoia's track record was smashed thanks to one poor investment: Valeant Pharmaceuticals International.
An unmitigated disaster
At one point, as much as 36% of Sequoia's portfolio was invested in Valeant. This positioning didn't raise many eyebrows at the time because the fund had a history of taking significant positions in its favorite companies. However, when Valeant blew up in 2015 and the stock lost around 90% of its value, Sequoia's value plunged almost 50% from peak to trough, erasing three years of gains.
Sequoia's fatal dance with Valeant, which is now known as Bausch Health Companies Inc. (BHC, Financial), is a cautionary tale to investors about the risks of getting too besotted with one particular investment. At the 2016 Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) annual meeting of shareholders, Buffett was asked to weigh in on this topic and offer his views as to why the fund made this significant mistake.
After praising the investment manager's long-term track record, the Oracle of Omaha said:
"I think it was a very unfortunate period when the manager got overly entranced with a business model, which, if you — I watched the Senate hearings a couple of days ago when Senator Collins and Senator McCaskill interrogated three people from Valeant, and it was not a pretty picture.
In my view, the business model of Valeant was enormously flawed. It had been touted to us. We had several people who urged us, strongly, to buy Valeant, and wanted us to meet Pearson, and all that sort of thing."
Buffett says he turned these people away for two reasons. First, he thought the company's business model was "enormously flawed." Second, he didn't believe management had "integrity," which was a big red flag.
"But it illustrated a principle that Pete Kiewit, I think, said many, many years ago. He said if you’re looking for a manager, find somebody that’s intelligent, energetic and has integrity. And he said that if they don’t have the last, be sure they don’t have the first two.
It may take a while, but Charlie and I have seen, and we’re not remotely perfect at this, I don’t mean that, but we’ve seen patterns. You get — pattern recognition gets very important in evaluating humans and businesses. And, the pattern recognition isn’t 100%, and none of the patterns exactly repeat themselves, but there’re certain things in business and securities markets that we’ve seen over and over, and that frequently come to a bad end but frequently look extremely good in the short run."
Management quality is key
This is an exciting lesson for investors because it shows just how important management is for a favorable investment outcome.
Buffett didn't like Valeant because he didn't trust the quality of the company's management team, which cost him billions in the short term but turned out to be the right decision over the long term.
Of course, as he alluded to in the quote above, assessing the quality of management isn't a precise science, though there are common factors that always link bad management, such as poor corporate governance, excessive pay, price gouging and empire building. More than one of these factors were present at Valeant under its former management team.
Disclosure: The author owns shares of Berkshire Hathaway.
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