The investing process is all about trade-offs, or compromises. One of those critical trade-offs is between concentration and diversification. You might earn more by concentrating on a small number of stocks, but if one or more of those stocks in which you concentrated goes bad, your whole portfolio will look grimmer.
That’s one of the principles behind index investing, for buying a cross-section of the market. Active managers are not paid to deliver what are essentially indexing results, however, so most focus on a limited number of high-potential stocks.
Chapter 11 of Michael Batnick’s book, “Big Mistakes: The Best Investors and Their Worst Investments,” uses the example of the Sequoia Fund to illustrate how falling in love with one of the stocks in a concentrated portfolio can nearly kill a fund.
When Warren Buffett (Trades, Portfolio) decided in 1969 to shut down his limited partnership, he wanted to protect his investors, who on their own might be taken advantage of by sharks. So he worked with Bill Ruane of Ruane, Cunniff & Goldfarb to set up the Sequoia Fund to handle their investments.
Not surprisingly, the Sequoia Fund looked like a Buffett product, long-term investments based on extensive research. As value investors, they also bought only when shares were available at significant discounts to their intrinsic value and were protected by a strong moat. One of its major investments was Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial); it was the fund’s largest single holding between 1990 and 2010.
Another of its investments was O’Reilly Automotive (ORLY, Financial). The fund bought it in 2004 at $19.84 and, by 2017, the stock was close to $240. The purchase was based not only on financial analysis, but on 100 visits to retail stores by the fund’s director. And while the stock price was drawn down by almost 40% in 2017, the fund wasn’t heading for the exits.
Where Sequoia did get caught was with Valeant, and Batnick describes that big mistake as self-inflicted.
Valeant Pharmaceuticals (now Bausch Health Companies (BHC, Financial)) used to be a star performer. Under the leadership of CEO Mike Pearson, the company focused heavily on buying existing drugs and then raising their prices. For example, it bought Medicis and got its hands on calcium disodium versenate, a drug used to treat lead poisoning. It then raised the price from $950 to $27,000.
Batnick wrote that Sequoia rode Buffett’s coattails to achieve its first outstanding results, and then hoped to ride Pearson’s in the same way. But, he wrote, “Mike Pearson was certainly shareholder focused, but that is where he and Warren Buffett's similarities ended. Talking about Pearson, Buffett said, 'If you're looking for a manager you want someone who is intelligent, energetic, and moral. But if they don't have the last one, you don't want them to have the first two.'”
The fund began buying Valeant in 2010 and enjoyed the ride as the shares increased 70% that year. That made it the fund’s second-largest holding. In the first quarter of 2011, the stock moved up another 76% and became Sequoia's largest single holding.
The tide turned in September 2015, when Hillary Clinton, who was running for president, called Valeant’s practices “price gouging” and tweeted she planned to do something about it if elected. Over the following week, share prices of Valeant dropped by 31%. In October, the company took another serious hit as Citron Research accused it of fraud and drew parallels with Enron. It ended the day down another 19% and was down 50% overall.
Still, Sequoia’s managers kept the faith and sent a letter to shareholders expressing their continued confidence in the company and Pearson. And then it immediately bought even more Valeant stock, becoming the largest single shareholder of the company. Valeant also made up 32% of Sequoia’s assets.
The matchup did not have a happy ending; Batnick wrote, “Eight months after defending Pearson and Valeant, Sequoia would sell their entire position. Valeant lost more than 90% of its value in just a few months, and Sequoia, which had hitched its wagon to Valeant, saw its assets cut in half.”
The fund also lost the patient investors whom it had nurtured for decades, and now had to serve investors who wanted results immediately. Batnick sardonically noted, “Losing 26.7% in a 12”month period when the S&P 500 gained 4% was too much to bear. In 2013, Sequoia closed the fund to keep new investors out; as a result of the Valeant crisis, it could have used a lock to keep them in.”
Thanks to its adventures with Valeant, Sequoia’s assets dropped from $9 billion to less than $5 billion. Batnick wrote, “A single stock leveled one of the most successful funds of all time, you should think twice before putting yourself in the same type of situation.”
Batnick told readers they could avoid getting into such trouble by writing down the reason they bought a stock, and to have an exit plan. He gave the example of being willing to risk 5% of a $200,000 portfolio, $10,000, by buying XYZ at $100. With those figures, you can work back to the price at which you would get out completely and cut your losses. In this example, that works out to $50.
“Diversification is slow and boring, concentration is fun and exciting. But if fun and exciting is what you seek, the stock market can be a very expensive place to find it,” he concluded.
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
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