Value Investing

Valeant contributed -6.3% to Sequoia’s return of -7.3% for the year

Sequoia Fund 2015 Annual Letter

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Sequoia turned in its second straight year of poor results in 2015.Teasing out the source of our underperformance doesn’t take much work. We began the year with a 20% weighting in Valeant Pharmaceuticals. Valeant rose by more than 80% through the summer, driving very strong gains for the Fund. But the price collapsed in the fall amid revelations and allegations about the company’s business practices. Ultimately, Valeant declined 29% for the year and by more than 70% from its 52-week high to its low. We bought more shares in October, and we calculate that Valeant contributed -6.3% to Sequoia’s return of -7.3% for the year.
At its peak price, Valeant constituted more than 30% of the Fund’s assets. We’ve been criticized for allowing the holding to grow so large, but our feeling before the crisis erupted was that Valeant was executing well on its business model. Earnings were growing rapidly and we believed the company was making intelligent acquisitions that were creating shareholder value. Valeant was taking outsized price increases on a portion of its drug portfolio, but the entire branded pharmaceutical industry routinely has taken substantial annual price increases on drugs for more than a decade.
As you are no doubt aware, Valeant was rocked in the fall by the closure of an affiliated specialty pharmacy, Philidor, after health care payers said they would not reimburse Philidor for claims it submitted. It has been further buffeted by subpoenas from Congress over its pricing strategies and by regulatory and law enforcement scrutiny over practices at Philidor. A committee of Valeant’s board of directors is investigating the relationship with Philidor. Valeant recently said it would restate prior earnings as it improperly accounted for sales to Philidor in late 2014.

As these inquiries continue and Valeant remains a subject of intense scrutiny, the share price is very unstable. For the stock to regain credibility with long-term investors, Valeant will need to generate strong earnings and cash flow this year, make progress in paying down some of its debt, demonstrate that it can launch new drugs from its own development pipeline and avoid provoking health care payers and the government. The company has committed to doing all of these things and we are confident interim CEO Howard Schiller and interim board chairman Robert Ingram are focused on the right metrics. Before CEO J. Michael Pearson went out on an extended medical leave, he also seemed committed to this path.
In the end, Valeant’s ability to grow earnings over a period of years will determine the stock price. A few months ago, the consensus cash earnings estimate from Wall Street analysts for Valeant in 2016 was about $16 per share. Today, estimates are closer to $13.50. This represents material deterioration, but still good growth over 2015 results. And with strong performance from its gastrointestinal drug Xifaxan and a slate of new product releases in 2016, Valeant has the potential to grow earnings for several years driven more by organic volume increases than price hikes.
As the largest shareholder of Valeant, our own credibility as investors has been damaged by this saga. We’ve seen higher-than-normal redemptions in the Fund, had two of our five independent directors resign in October and been sued by two Sequoia shareholders over our concentration in Valeant. We do not believe the lawsuit has merit and intend to defend ourselves vigorously in court.
Moving along, Valeant was not the only problem with our portfolio last year. The non-Valeant portion of Sequoia modestly underperformed the Index.
Berkshire Hathaway, our second largest holding, declined by 12.5% during the year. Berkshire now trades at less than 12 times our estimate of 2016 earnings. We think Berkshire grew its earnings at a high-single digit rate in 2015 but many of its individual operating companies face challenges. Railroad volumes declined abruptly at year-end and the outlook for 2016 volume is poor. GEICO’s auto insurance profit was off and many of Berkshire’s other service and manufacturing businesses were soft. Berkshire committed over $40 billion to acquisitions in 2015, the bulk of it to buy Precision Castparts.
Our European holdings continued to turn in poor performance. Rolls-Royce fired its CEO John Rishton and replaced him with a board member, Warren East, who had great success leading the semiconductor company ARM Holdings. Mr. East knows what he is doing but he’s got his work cut out for him as he tries to improve operating discipline at this inefficient manufacturer. Rolls and our UK holding IMI plc were the two worst-performing stocks in Sequoia, each declining about 35% in dollars.
A striking fact about 2015 is that the Index rose 1.4% for the year, but the so-called FANG stocks – Facebook, Amazon, Netflix and Google – accounted for more than 100% of the S&P’s total gain, meaning the other 496 stocks cumulatively declined. The securities firm Jefferies provides more detail about the dispersion of returns: as of late January, about one-fifth the stocks in the S&P 500 were at least 40% below their 52-week highs. Essentially, we are in a bear market for stocks (and most other asset classes) mitigated by extreme strength in a small number of businesses, mostly in technology.
Sequoia reflected this bifurcation. Though the Index moved up by a modest 1.4% for the year, only eight of our 38 stocks rose or declined by a single digit percentage in 2015. Thirty stocks moved by double digits, either up or down. Among our top eight holdings: Valeant declined 29%, Berkshire declined 12%, TJX rose 5%, O’Reilly rose 32%, Fastenal declined 12% and MasterCard rose 14%. Precision Castparts declined by 4%, aided by the decision to sell to Berkshire. Our eighth largest position, Alphabet (nee Google), rose by 47%.

This is not mentioned to rationalize our weak overall performance. In fact, the market‘s logic was clear. The few companies showing good growth were rewarded with sharp increases in their stock prices. The preponderance of large US businesses that showed little or no growth got punished. Our portfolio was no different, with the notable exception of Valeant, which grew earnings but saw its stock value plummet.
Every year in this letter we remind Sequoia shareholders that we have a distinct investing philosophy. For 46 years we have endeavored to concentrate our investments in a relatively small number of companies that we have studied intensively and purchased carefully, in the belief that such a portfolio will generate higher returns over time with less risk than a diversified basket of stocks chosen with less care. Our results over the past two years are very disappointing, but our commitment to this process has not changed.
We also communicate clearly that a concentrated portfolio of stocks will not perform in line with the S&P 500 Index from year to year. It is common for Sequoia to generate returns far out of line with the Index. In seven of the past 16 years Sequoia’s results differed from the Index return by at least 10 percentage points. Five times we outperformed by more than 10 percentage points and twice we’ve underperformed. We underperformed by about 8.7 percentage points in 2015.
As of this writing, our top 10 holdings make up about 70% of Sequoia’s portfolio. Given this, you should expect performance variance from the Index from year to year. Valeant continues to be our largest holding and if it does not recover our future performance may lag the Index.
We have changed the venue for our annual meeting with Sequoia shareholders and other clients. We will meet with you on Friday, May 20 at 10 am in the Grand Ballroom of the Plaza Hotel in New York City. We’re moving the meeting to the Plaza as it is a large venue and we expect attendance to be high this year. Please make note of the change.
Sincerely,
Robert D. Goldfarb David M. Poppe
President Executive Vice President

 

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