Robert D. Goldfarb’s Sequoia Fund, Inc. letter to shareholders for the fourth quarter 2014.
This is one of our favorite letters so we hope you enjoy it! Also see Sequoia Fund Investor Day: Full Transcript
Sequoia Fund’s results for the quarter and year ended December 31, 2014 appear below with comparable results for the S&P 500 Index:
The numbers shown above represent past performance and do not guarantee future results. The table does not reflect the deduction of taxes that a shareholder would pay on Fund distributions or the redemption of Fund shares. Future performance may be lower or higher than the performance information shown.
*The S&P 500 Index is an unmanaged capitalization-weighted index of the common stocks of 500 major US corporations. The performance data quoted represents past performance and assumes reinvestment of distributions.
The investment return and principal value of an investment in the Fund will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Year to date performance as of the most recent month end can be obtained by calling DST Systems, Inc. at (800) 686-6884.
The Fund outperformed the S&P 500 Index in the fourth quarter while underperforming the Index for the year. While we know a concentrated portfolio of stocks frequently will perform out of sync to the broader basket of stocks that constitute the Index, we nevertheless were disappointed with our performance in 2014.
Sequoia Fund: Underperformance attribution
We would attribute our underperformance to two factors, with a third issue that bears watching. First, the Fund held, on average, approximately 15% of its assets in cash during the year. This ranged between 20% cash at the start of the year and 12% in the fall. With cash generating negative returns, net of our fees, and the Index returning 13.7%, our cash position accounted for more than one-third of our 614 basis points of underperformance.
Second, our European holdings turned in mostly disappointing performance. About a decade ago we began trying to identify great businesses in Europe that source a growing percentage of their earnings from the emerging world. In 2004, many US businesses were still quite dependent on the domestic market while European companies tended to be more global, or so we felt. At the same time, we felt Europe shared similar standards of corporate governance with the U.S. We started 2014 with 7.1% of the Fund’s assets invested in UK-headquartered companies and 4.1% in two companies on the Continent, for a total of 11.2% invested overseas.
The UK Index, known as FTSE 100, rose 0.7% for the year, far below the S&P 500. On the Continent, our largest holding was Pirelli, the Italian maker of performance tires. Pirelli was down about 11% in dollars in March when we sold it, but had been a solid performer previously. We didn’t sell because of short-term price gyrations but because of concerns over corporate governance. The family that controls Pirelli had decided to sell a significant ownership stake to Rosneft, the Russian oil company that is aligned with President Vladimir Putin. We opted to exit immediately.
Sequoia Fund: Portfolio holdings
If Pirelli was a disappointment, the performance of our UK holdings in 2014 was a horror show. Rolls-Royce, our largest UK position, seems willing to destroy shareholder value in the name of diversification. Rolls-Royce has a world class business making engines for wide body jets. These engines are often sold at breakeven prices, or even a loss, but come with long-term Total Care service contracts that are quite profitable. Rolls shares a duopoly with General Electric in wide body engines and the barriers to entry for any newcomer would be formidable. Not only is the business intensely regulated, but a new player selling jet engines without an installed base of profitable service contracts likely would lose billions of dollars to capture market share from GE and Rolls. Not surprisingly, Rolls earns more than a 20% return on invested capital in civil aviation and its installed base of service contracts and strong backlog suggest Rolls should grow profitably for years to come.
And yet Rolls’ board of directors decided that it wanted to diversify deeper into the marine engine and power generation businesses, competitive sectors that are being encroached by low cost Asian players. To pursue this strategy, the board appears to have pushed out a sitting CEO who had crafted the successful Total Care service contract selling model, and replaced him with John Rishton, a board member who, in our meetings with him, has shown minimal awareness of the returns on capital his acquisitions have generated.
Rolls’ stock declined more than 30% in sterling during the year as investors lost confidence in management. We held our shares in the belief that Rolls’ wounds are self-inflicted and reversible. The recent share price does not properly value the civil aviation business even if we ascribe little value to the marine and energy businesses. However, management and the board seem stubborn and entrenched, and it may take a tough-minded activist to force strategic change.
Yet another British company in our portfolio, IMI, chose to force a successful CEO into early retirement and replace him with a newcomer because the board of directors wished to change strategy and pursue more acquisitions. Never mind that the existing management had been enormously successful. IMI shares declined 14% during the year in sterling (adjusting for a return of capital during the year). In fairness, we believe the new CEO is quite capable. Other UK holdings like Croda, Hiscox and Qinetiq were flat or down for the year, with the roughly 5% decline in GBP/USD exchange rate a further headwind.
The British take pride in their system of independent board chairmen, but the chair is often a retired CEO from an outside industry rather than an owners’ representative who knows the business. These gray alpha males frequently seem determined to inflict their will on the management teams they oversee. The U.S. system, in which one person often controls both management and the board, can be problematic when the leader is mediocre. But in the UK system it sometimes feels like the boards can’t bear to let management lead. Perhaps that helps explain why the FTSE 100 has lagged the S&P 500 by wide margins over the past five-, ten- and thirty-year periods.
In case it’s not clear, we are disappointed with our track record in Europe. Unfortunately, we’re slow learners. We bought two new positions in Europe during the year, one of which already has been sold at a loss. The other, Richemont, ranks among the great luxury houses globally: we believe Cartier is the strongest jewelry brand in the world and is flanked by a stellar portfolio of Swiss watch brands. As the emerging world grows wealthier, we believe the newly affluent will seek ways to project status and enjoy their wealth, benefiting Richemont and our long-time holding Tiffany. The chairman of Richemont is also an owner whose family built the company over decades. We’re hopeful that will make a difference.
Sequoia Fund: The trend to passive investing
A third issue we’ve been thinking about is the trend to passive investing. We are believers in the “fairly efficient