the Sequoia Fund (ii)

large position sizes

At the end of June 2015, the Sequoia Fund had assets of $8.7 billion, of which 28.7% was in shares of Valeant Pharmaceuticals (VRX) and another 10.6% in Berkshire Hathaway.

How did these positions get so large?

a.  The portfolio managers chose to have nearly 40% of their fund in two names.  In fact, as VRX began to decline in the second half of last year, the managers bought more.

Don’t ask me why.  To my mind, following Bernard Baruch’s dictum to have all one’s eggs in one basket may have been ok for the renowned speculator way back when, but it makes no business or economic sense for mutual funds today.  According to the Wall Street Journaltwo members of the board of directors of the fund resigned last year because they disagreed so strongly with the strategy.

b.  SEC diversification rules permit this.  The pertinent regulation has two parts:

  1.  The fund can’t make a purchase of a security if doing so would make its total holding in the security more than 5.0% of fund assets.  At the 5% threshold, the manager can allow the existing position to grow; he just can’t buy more.  Growth can come because the security is outperforming and/or because the total asset size is shrinking.
  2. 25% of the fund’s assets are exempt from rule 1.

The second provision is much less well-known than the first.  I’m not sure why the SEC wrote the rules the way it did (my guess would be lobbying from the fund management industry), but I can’t recall an instance where having a whopping position like Sequoia has with VRX didn’t end in tears.  And I can only recall two other cases, one involving a junk bond fund, another a Pacific Basin fund, where managers took such large bets with shareholder money.

More tomorrow.


2 responses

  1. Dan
    I’ve read some of your posts this year as I may have become aware of the site’s existence because your Holiday card mentioned it. So because I know more about Sequoia than you seem to I thought to tell you some of what I know; as I think this is one of the more interesting but disquieting events I have seen since Madoff (not that they are similar but they both have really bothered me). And I am not an expert on Sequoia or Valeant but know something about both of them.
    Sequoia is the main fund for Ruane Cuniff and Goldfarb. When Warren Buffett closed down his hedge fund and rolled everything into Berkshire Hathaway the only firm he recommended his clients put money with was Ruane Cuniff. (I think it is possible that Sequoia was formed for the purpose of accommodating this demand- but I could be wrong about this.).
    Ruane and Cuniff were investors/high net worth brokers at I think Kidder Peabody (so by the way was Julian Robertson). Goldfarb who is younger joined the firm in 1971 I think. Both Ruane and Cuniff are no longer alive but from everything I’ve read they were very strict value investors and very nice charitable people. Goldfarb is a Summa from Yale and a Harvard MBA.and I guess became the key man in the firm when the founders retired.
    For many years the largest position in the fund was BRK/A and it may have been over 25 or 30% of the fund; but I don’t know about this for sure.
    The fund has had long term good-great performance and has always been very concentrated.
    On the board- and I think the chairman- is Roger Lowenstein the well know and highly regarded financial journalist.
    I think I’ll stop now and you can do you own research. But I thought you might want some background before you write too much about this situation.
    One last thing. The analyst who followed VRX and for that matter ORLY and probably some others in the fund is a 2009 Harvard graduate name Rory Priddy (or something like this). Seems odd to have bet so big (too big even if it had worked) based upon the analysis of one young analyst. And he seems to have just left the firm.
    Where was Goldfarb while they made such a big bet on such and opaque company? At least with BRK they knew Buffett and the company was somewhat diversified.
    I have no knowledge about Goldfarb other than that he is a long term person there -45 years- and was good at school. He seems to have just retired.
    It is too bad that this fund with such a good long term record screwed up their long term record.

  2. Hi Steve,

    Thanks for your comment. As it turns out, I had lunch with a former colleague yesterday who said many of the same things you do. He added that Ruane… made its reputation by early shrewd investing in small Silicon Valley companies a generation ago.
    You’re also right that a decade or more in the past, when Sequoia was smaller, Berkshire Hathaway made up 30% or more of the fund’s holdings. From what I could tell, for other stocks Sequoia seemed to take 5% initial positions and to begin to trim if/when they exceeded 15% of the fund.
    It also struck me that post-2009, Sequoia maintained a much larger than normal cash position at around 25% of assets.
    If my impression of how Sequoia operated is correct, Valeant is an outlier, in that the initial position seems to have been about 10% of the fund, bought in the second half of 2011, and that Sequoia doesn’t appear to have begun to trim even when the position rose to 30% of assets.
    My back of the envelope calculation gives me the impression that Sequoia, maybe because of the large cash position, had not performed particularly well in the post-recession market recovery. Who knows, but maybe Sequoia wanted to squeeze something extra out of VRX to make the near-term record look a bit better.
    My main/only interest in Sequoia is that it is making redemptions in kind, something I think may become more common, and potentially unpleasant for shareholders, if junk bond funds get in trouble.
    As to VRX, I know almost nothing about the company, and hindsight is always 20/20. Still, I find it striking that despite fabulous earnings growth, the PE never wanted to expand and that the best healthcare investors I know of were unwilling to touch it.


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