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.
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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 market theory” and understand that it is difficult to outperform the S&P Index. But neither is it impossible, as reflected by the fact that a meaningful number of active investors beat the Index consistently over long time periods. But individual investors increasingly seem persuaded that it is so difficult to outperform that they are better off in low-cost Index funds.
The mutual fund ratings service Morningstar estimates that $98.4 billion exited actively-managed US equity mutual funds in 2014, while $166.6 billion flowed into passively-managed strategies such as Index funds. The market cap of the S&P 500 is about $19 trillion at this writing, so this movement may not have an observable impact on stock prices. Still, the net effect is stocks in the Index get bought and stocks outside the Index get sold without consideration of the merits of the decision. In turn, this means the Index will outperform the rest of the universe of US stocks.
We can’t say with any confidence that the trend to indexation hurt our returns in 2014. Our holdings Valeant, Idexx Labs and Sirona are not in the S&P 500 and each turned in outstanding share price performance. But the S&P 500, the largest and most important benchmark for most investors, rose 13.7% during the year, while the Russell 2000, a broader Index that includes smaller companies, rose 4.9%.
Vanguard says active managers control substantially more assets than passive managers, meaning the rotation to Index funds could continue for years. Indexation derives from a valid premise that active managers have created an efficiently priced market and, because they charge high fees, will underperform that market. Academic studies show passive strategies tend to outperform active managers in bull markets, perhaps for the simple reason that it works to be 100% invested in stocks when markets are rising. But studies also show passive strategies tend to underperform in bear markets, as it can hurt to be fully invested when stocks are dropping. If the trend to indexation continues, underperforming active managers will either slash their fees, disappear, or some of both.
One reason we think the trend could have legs is that markets continue to grow more efficient. Our colleague Greg Alexander likes to say “the Index is a lot better than it used to be.” U.S. corporate managements are generally competent and focused on creating shareholder value. There are not a lot of mutts left in the kennel, so to speak, so winning the dog show is harder. Over the past 10 years the Fund has outperformed the Index by about 150 basis points per year, or 9.2% vs. 7.7% annualized. This is well below our 45-year track record of 14.5% annualized vs. 11.0% for the Index. Yet it still ranks us in the upper tier of large US mutual funds over the past decade, per Morningstar.
We always aspire to improve, but the limitations imposed by our large size, the quality of the Index, the greater flow of information into the marketplace and the sheer number of smart people picking stocks for a living make it challenging to outperform. We haven’t helped ourselves with our foray into Europe.
Sequoia Fund: Issues with Valeant
A topic many shareholders and clients wanted to discuss with us in 2014 was Valeant. It is the largest holding in Sequoia by far. One could argue Valeant wasted much of the year on a quixotic effort to buy Allergan, maker of Botox. Allergan had no interest in being acquired and fought a vicious and savvy public relations campaign to portray Valeant as unworthy of marriage to such a prized catch. In the end, Allergan found a suitor more to its liking in Actavis, and Actavis agreed to pay a substantially higher price than Valeant had offered.
In our opinion, much of what Allergan said was wrong but Valeant seemed unprepared for what it should have known would be an aggressive counterattack. The defenses available to the targets of hostile takeovers are considerable and Valeant has now lost three hostile bids for public companies since 2011. Meanwhile, Allergan’s stock price nearly doubled over the past year without so much as a thank you note sent to Valeant CEO J. Michael Pearson.
Some good came out of this defeat. As it fought for Allergan, Valeant stopped making other acquisitions and so stopped taking one-time charges for restructuring and integrating its serial acquisitions. This made its financial reports easier to follow, and more investors came to see Valeant has a fine business. Most of its product categories show strong organic growth, despite claims to the contrary by Allergan. Valeant throws off sizable cash flows. It has very few products vulnerable to patent expirations in coming years. Management has done an excellent job of picking its spots, both geographically and by product category, while avoiding dependence upon a single drug. It integrated the large Bausch & Lomb acquisition flawlessly. And it proved itself capable of launching a new prescription drug, Jublia, with a highly-successful direct-to-consumer ad campaign.
In short, Valeant lost the battle for Allergan but we believe it is winning the war to establish itself among the first rank of global pharmaceutical companies. The stock suffered for much of the year from Allergan’s broadsides, but performed better once the takeover battled ended. We think Valeant is poised for more growth, both organic and acquired. We think it is brilliantly managed by Mike Pearson and his team. And yes, we are comfortable with the size of our holding.
Sequoia Fund: S&P earnings growth
Over the past five years, stock prices have doubled. Sequoia has done a bit better than that. The forward PE for the Index is now 17x, while the consensus estimate for S&P earnings growth is about 3% as of this writing, and has been trending lower. The price-to-earnings ratio does not feel inflated relative to the minuscule returns on Treasuries, but it does feel high relative to earnings growth. US companies have benefited enormously over the past few years from low borrowing costs, inversions/shrinking tax rates, lack of wage inflation and overcapacity in China, which keeps production costs low for all manner of goods. Yet earnings are expected to grow in mid-single digits. What happens when some or all of these tailwinds dissipate? What if some or all of them turn into headwinds? We think investors should be prepared to earn modest returns from stocks over the decade ahead.
The Fund is closed to new investment and partially as a result we had a net outflow during 2014 of $539 million, or 6% of assets. We lagged the Index for most of the year, and we saw redemptions increase over the summer and fall. A lot of the outflows came from financial advisors who manage their businesses on the Schwab, E*Trade and Ameritrade platforms, and who bought into Sequoia fairly recently. Given the instability of this client base, we continue to prefer direct relationships with like-minded shareholders to shelf space in a financial supermarket.
At year-end, the 10 largest stocks in the Fund constituted 63.8% of our net assets and 73% of our investment in stocks. We are comfortable with this level of concentration but would note that in seven of the past 15 years, Sequoia’s return has been at least 10 percentage points different than the S&P 500 Index return. Five times we’ve outperformed by at least 10 percentage points and twice we’ve underperformed by at least that much.
Sequoia Fund: Short-term direction of the market
As for the year ahead, we’re skeptical anyone can predict the short-term direction of the market, and certainly we have a proven inability to do so. We believe we best serve Sequoia shareholders by endeavoring to own a concentrated portfolio of stocks that has been intensively researched and carefully purchased, 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.
Beginning this year, we are making a change to our communications with shareholders. Henceforth we will send an annual report that includes a letter from the co-managers and a discussion of our larger holdings, and a semi-annual report that includes the transcript of our May investor day meeting. We will stop sending reports after the first and third quarters. Few mutual funds send out reports after all four quarters and regulators do not require it. We believe our investor day meeting transcript provides a level of disclosure well beyond that provided by most other funds. The first and third quarter reports, by comparison, had become a chore for us to prepare and not especially useful for investors.
We are pleased to report that Vinod Ahooja has rejoined the Sequoia board. Vinny previously served 12 years on the board before retiring two years ago. We’re delighted to once again enjoy the benefit of his wise counsel.
Finally, we suffered a loss in 2014 when our co-founder Richard T. Cunniff passed away in March at the age of 91. Rick fought courageously in World War II and was both a gentleman of the old school and a fine stock analyst. He loved this firm and was greatly admired by all who worked here. Bill Ruane often said that he wouldn’t have had the nerve to start his own firm had Rick not been beside him. We are proud to have known Rick.
Robert D. Goldfarb
David M. Poppe
Executive Vice President