Sequoia Fund investor day transcript for the month ended June 30, 2017.
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Good morning. Welcome to our 2017 Investor Day. I am David Poppe, and I am joined on the dais today by members of the Ruane, Cunniff & Goldfarb Investment Committee: John Harris, Arman Gokgol-Kline, Trevor Magyar, and Chase Sheridan, plus non-voting but always helpful member Greg Alexander. Also on the dais with me are our most famous analyst and late arriver, Johnny Brandt, Greg Steinmetz, and our new head of operations, Wendy Goodrich. In the front row is the rest of our exceptional research team whom I will introduce in a bit, and which we believe is the strongest group in our industry. It is good to be with you, and especially to see so many familiar faces in the audience today. We certainly appreciate the trust that you have placed in us.
As we did last year, we would like to spend the first part of the meeting today updating you on what is happening inside our firm and at the mutual fund. I will provide an overview of the day. John Harris will talk about why we feel confident in our process and our culture. Next, members of the team will give short presentations on some key initiatives happening inside Ruane, Cunniff. This should take a little less than an hour, and leave plenty of time for questions. We will finish the formal program at about 12:30 PM, but we will stay here for another half hour or so to answer any individual questions that you may have. We do need to clear the ballroom by one o’clock.
A year ago at this meeting, we tried to address directly what we saw as the major issues facing our firm: what leadership would look like going forward, what needed to change, what was too important to change. And while 2016 was a very trying year for us and for you, I am proud that we have done the things we told you we would do. Since the leadership change, we have retained all of our key employees and the vast majority of our clients. We are investing in our business. On a personal level, all of us on the dais have invested our own money in the business. On a professional level, we are investing in our people; we added two excellent analysts in January. And we are implementing new technology. Last fall we hired a new head of operations, Wendy Goodrich.
Among her many duties, Wendy is reviewing and upgrading our internal technology. She is off to a great start, and you will hear more from her in a few minutes. We intend to invest more in our client service function this year, something my partners will talk more about in a bit.
On the investing side, as you probably know, we experienced an elevated level of portfolio turnover relative to our history. We know it is painful for taxable shareholders and other clients to pay the toll on capital gains in a year when performance is poor. And it is only lukewarm comfort to recall that those gains were a result of years of mostly terrific stock performance and tax-deferred compounding. However, we believe the decisions to sell were sound.
We certainly did not top tick every sale, but taken in aggregate, the stocks we sold over the past year have underperformed the S&P Index since our sale. We also purchased eight new securities. Of course, one year does not a record make, but those eight stocks have in aggregate outperformed the S&P since initial purchase. Today, these eight securities account for nearly one quarter of Sequoia’s assets. The result of this activity is a re-focused portfolio. When I became CEO in April 2016, Sequoia consisted of investments in 33 businesses. At the end of the first quarter of 2017, we held 26 positions. We are very pleased both with the initial performance of the stocks and, more importantly, with the health of the businesses we now own.
Given the unusual level of activity in the portfolio, it is natural for clients to ask how we are changing. I would say that we are rededicated to the principles of investing that we learned from our founders. While our portfolio is more focused than it was a year ago, it is less concentrated in our largest holdings. We are working hard every day to identify terrific businesses trading below their intrinsic value. The overall stock market today is expensive. There are precious few cheap stocks, but we are value investors. We continue to invest with a long-term focus, trying to identify and buy for responsible prices businesses with the potential to grow for years. At a time when many smart people are looking at every good idea, we think our ability to invest with a long-term horizon is a competitive advantage, as the intrinsic value of long-duration growth can often be underappreciated by investors distracted by short-term momentum. We play to our strengths.
This gets to another issue, which is the wisdom of establishing an Investment Committee. I will repeat today what I have said many times now over the past year, which is that you should think of us less as a committee and more as a team. For one thing, the six of us including Greg Alexander have a total of 98 years of experience at Ruane, Cunniff. We have worked side by side for the past decade. We all came to Ruane originally because we wanted to be great investors and we have all internalized the culture and values of Ruane, Cunniff & Goldfarb. My colleagues have been the primary idea generators for the last ten years, not just the past year. I want to take just a moment to comment on the recapitalization transaction that you were contacted about in the spring. In March, Sequoia shareholders and separately managed account clients were asked to approve a transaction through which we sold a block of stock to some of our senior employees. Technically, this constituted a change of control. As a practical matter, the change of control happened a year ago when Bob Goldfarb retired. We sent out a similar consent letter twelve years ago after Bill Ruane’s death when we repurchased shares from his estate. Bob Goldfarb remains a stockholder of the business, as does the Cunniff family. Our current employees now own a much larger percentage of the company than they did before, and they have tremendous incentive to stay and make our business more successful. In addition, as I mentioned, all six members of our Investment Committee invested in Sequoia Fund in 2016, and we will invest in the fund in 2017. We are putting even more of our money where our mouths are.
That is a high-level look at activity inside our firm. I would like to now provide you with a little more perspective on our investment strategy. We think it is critical that you understand it. Why? Because the stock market ebbs and flows, and over short periods of time can be highly unpredictable. There is nothing we can do to make short-term performance more consistent. However, if we are doing our jobs right, we should have a predictable investing process that makes sense to you even in periods when returns suggest we are out of sync with the market. You should feel like a partner in this process because to a great degree our clients make our investing style possible. I believe that what I am about to say is almost exactly what Bill Ruane would have said twenty years ago, minus the Yogi Berra-isms.
Let’s start with the obvious. We are value investors. The principles underlying our investment strategy were handed down to us from Benjamin Graham. These principles are tried and true, and they have served our clients well for over 45 years, years that have seen a variety of market conditions and a variety of people managing the Sequoia Fund. Of course, value investing does not automatically work for everyone. The power of the principles of value investing, like those of a lot of concepts, is heavily dependent on the way that one applies them.
Let me repeat an overly long sentence from our most recent quarterly letter: ‘‘Our mandate is to invest Fund assets in a select group of structurally-advantaged companies run by able managers and/or visionary entrepreneurs which we believe will compound our capital at attractive rates over the long-term.’’ In this sense, we are value investors with an important overlay. We care about great businesses and great people, not just great prices.
We are very focused on owning high-quality companies. One simple way to think about quality is that by our math, the return on equity for our portfolio is significantly higher than the ROE for the S&P 500. And over the past three years, our companies have grown their earnings faster than the Index components. According to consensus estimates and our own internal estimates, our companies are expected to grow faster in the future as well.
The P/E multiple for Sequoia is about 10% higher than it is for the Index right now. So while a portfolio that grows faster than the Index and earns higher returns than the Index but trades at a small premium to the Index may not outperform in a given year, we like the long-term math. The math on our portfolio’s growth and returns also underscores our qualitative sense that we own a collection of first-rate companies and management teams.
Why the overlay of quality? We do not invest in structurally-advantaged businesses and able managers because we admire them, although, as students of business, we generally do admire them. We invest in these companies because we believe doing so is the best and most reliable way to make money, period. Why do we believe that? I think it really comes down to knowability. We are by constitution and experience humble about what we can know, and in the short term, businesses, regardless of quality, are subject to a variety of forces into which we can have very little insight. The natural ebb and flow of our businesses is something we study with great intensity and interest, but it is not what drives our investment decisions.
What does drive our investment decisions is our assessment of how businesses are likely to perform over the long-term. For us, this is much more knowable. We definitely favor businesses that grow, but even the fastest-growing business we invest in must have a wide and durable moat. Competitive advantages come in many forms, but what all such edges do is allow a business to earn superior returns now and, if these advantages are durable, into the future as well. We like businesses that control their own destiny.
The key here is that we believe that the overall quality of a business and particularly the significance and durability of its competitive advantage are knowable and more reliable indicators of wealth creation than short-term performance. Overall business quality is never perfectly knowable, of course. And creative destruction is always occurring. But with hard work, careful thought, and vigorous debate, we think we can make very well-informed judgments.
The market is smart. Business quality is clearly well-appreciated. High-quality businesses rarely trade for truly bargain prices, making life hard on the value investor. But businesses do periodically trade at a discount to their intrinsic value, and what we spend nearly all of our time doing is looking for these opportunities to act. This work is inherently labor intensive and highly qualitative. For sure, we do all the standard financial analysis, but many important business characteristics cannot be reduced to a spreadsheet. We need to make judgments about the quality of management teams, the viability of their strategies, the acumen of their competitors, and ultimately the durability of their competitive advantages. These are all subjective judgments. We have, over the course of 40-plus years, developed and refined a framework for thinking about business quality, a process for researching it, and a shared language for talking about it. If we have any intellectual property, this is it.
Hopefully that gives you a sense of the kinds of companies we want to buy: high-quality enterprises trading at discounts to their intrinsic value, with long-duration growth opportunities. I would note that every great outperformer we have purchased during my eighteen years here—from Fastenal to Idexx to Mastercard to O’Reilly to Precision Castparts to Sirona to TJX—had something in common. And it was not a low P/E at the time we first invested. It was a long growth runway and, most often, a long organic-growth runway.
I want to talk next about why we hold our companies for the long term. Again, I think the answer gets back to humility and knowability. After lots of hard work, careful thought, and vigorous debate, we may claim to know that a high-quality business is undervalued. But we will not claim to know its true value with any precision. The best that we can do — the best that anyone can do — is to identify a range for the true value of a business. This is the main reason we tend to hold our businesses even when the price-to-earnings multiples at which they trade expand beyond the price-to-earnings multiples at which we first purchased the stocks. Of course, if the market value of one of our businesses increases well beyond our estimated fair-value range, then we will sell it without emotion. But it is difficult to have true insight into an exceptional business, and if you do have an insight and are able to buy the shares below their intrinsic value, we have found that generally the best and most reliable way to make money in the future is to continue to own that business. Taxes and frictional costs play a role here, but our primary concern when we contemplate a sell decision is not taxes and frictional cost.
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