the Sequoia Fund (iii)

tax factors

Mutual funds are corporations of a special type.  In return for agreeing to limit their activities to portfolio investing and to distribute basically all their net realized gains to shareholders, mutual funds are exempt from paying corporate tax on those profits.  Net here means after subtracting realized losses.  Realized means that the winning/losing stock has been sold and the gain/loss recorded in the fund’s accounts.

Typically, distribution of gains occurs once a year, in November or December.

In my experience, almost no one other than the fund manager thinks much about the profits and losses imbedded in a fund, whether realized or unrealized.  There are certain situations, though, where they can be important.

net losses

In my career, I’ve turned around a couple of global mutual funds where the single most valuable asset on the day I arrived was the funds’ realized tax losses.  They allowed me to trade the portfolio aggressively without shareholders incurring any tax liability.

net gains

Most funds today are in the opposite situation.  Given that the S&P 500 is at all-time highs, funds tend to have large accumulated unrealized gains.  Tax on these gains is only due when stocks in the portfolio are sold and profits distributed to shareholders.  Also–and this is important–the tax is the obligation of the person who receives the yearend distribution.  That’s not necessarily the same as the person who enjoyed the rise in net asset value of the fund.

sales and redemptions

The potential per share value of losses falls if the fund is having net sales (meaning the number of outstanding shares is increasing), and rises if it is having net redemptions.

The potential per share tax obligation of gains also falls if the fund is having net sales and rises if it is having net redemptions.

the Sequoia situation

If the Wall Street Journal is correct, Sequoia is experiencing substantial net redemptions.  If it has to sell stocks where it has large gains in order to meet these outflows, it could be setting the stage for shareholders who stay loyal to the brand to incur a large income tax liability this year.

What the firm appears to be doing to reduce this burden on remaining shareholders is to meet large (over $250,000) redemptions mostly by distributing shares of stock from the portfolio rather than by (selling them and distributing) cash.

While this may be unusual and inconvenient to redeeming shareholders, it does not hurt them, since their cost basis on in-kind distributions is not the fund’s.  Rather, it’s the closing price on the day they receive the stock.  At the same time, distributing stock protects shareholders who don’t redeem from getting a whopping income tax bill at yearend.





the Sequoia Fund and redemption in kind

I read in the Wall Street Journal over the weekend that the Sequoia Fund (assets of around $5 billion) was experiencing heavy redemptions during 1Q16 and met them for some shareholders “in kind.”

Sequoia:  a first glance

I don’t know Sequoia at all.  A quick check of its December 2015 annual report shows the fund had what I judge to be a very unusual portfolio structure.  At that time Valeant Pharmaceuticals (VRX) made up 20% of assets (down from an even more whopping 28%+ in June of last year); Berkshire Hathaway, classes A and B, comprised another 13%.  That’s a third of the fund in two names.  Very concentrated, in my view.

Unfortunately for holders, VRX fell by 60% during the second half of 2015–during which time Sequoia boosted its position from 11.2 million shares to 12.8 million–before losing 2/3 of its remaining value since this January 1st. Hence the Sequoia redemptions …and the retirement of the fund’s senior portfolio manager.

The Journal reports that, in accordance with long-term fund policy, redemptions of $250,000 or more are being met substantially in kind, meaning that the seller is being paid mostly through a transfer of stock held in the fund portfolio, rather than in cash.  The WSJ cites one customer who received about 5% of his money in cash, the rest in shares of O’Reilly Automotive (ORLY).  That would probably mean less than 1,000 shares of a stock that trades 750,000+ shares a day.  So no liquidity problems.  Commission on the sale, other than benighted souls who patronize traditional high-cost brokers, isn’t a big deal, either.

How is this possible?

According to the WSJ (I haven’t checked, but I presume it’s a boilerplate feature of the prospectus), Sequoia discloses the policy of redemption in kind in its regulatory and marketing materials.

my thoughts:

I don’t ever recall hearing about redemptions in kind for retail investment products   before, although I suspect the provision is contained in every mutual fund and ETF prospectus.  The words “in kind” may not be there, but a general description of emergency measures likely is.

“In kind” strikes me as a draconian measure.  It certainly discourages/punishes redemptions.  And it’s not the sort of thing that encourages a customer to return at a later date.

It probably minimizes downward pressure on portfolio holdings from what would otherwise be forced selling by the fund.

It deals with tax issues in a way that doesn’t harm the redeeming customer and favors remaining shareholders.

How did the VRX position get so large?


More tomorrow.






what I find strangest about Valeant Pharmaceuticals(VRX)

Pharma company VRX went from about $20 a share in 2010 to a peak of $263+ last year.  It’s now trading at around $30.

To be clear, I don’t own the stock and never have.  My only acquaintance with the company comes through the financial media and the occasional analyst report–plus a fast look at the stock price history before writing this.

On the surface, the stock screens well.  Its ascent was mainly fueled by rapid earnings growth rather than by price-earnings multiple expansion.  The company seems to have served up continuing positive earnings surprises in a highly visible industry, where such operating performance for large companies is rare.  The only potential red flag I saw from historical data was the rapid build up of long-term debt resulting from VRX’s many acquisitions.

Among other places, I looked at an October 2015 report in Value Line.  I was mostly interested in the past financial reporting data the service provides, but I also happened to glance down at the accompanying commentary, which urges investors to buy.  The fall from $263 to $158 (the price on the date of the report) provided “a prime buying opportunity,”according to VL, with selling related to worries about drug price increases possibly “over done.”  The stock also received VL’s highest rank for Timeliness back then, a rating derived from a statistical analysis of prior financial and trading data.  My point is not to single out VL’s bad call,  but rather to illustrate that there was no obvious sign in historical data of the trouble the stock price was signalling.

What I find worthy of note:

  1.  The main drivers of the stock price seem to have been I’m-the-smartest-one-in-the-room-about-everything hedge fund managers, not traditional portfolio investors.
  2. Holders didn’t seem troubled by the fact that earnings growth was produced in considerable part by large price increases for mature drugs.  That’s OK for things like art works or prime real estate. But history shows Americans have a visceral dislike for companies that make large profits from human misfortune, especially form health problems.  Regulatory changes eliminating the profit “gouging” soon follow.  In my view, then, the whole VRX concept was trouble waiting to happen.  What veteran healthcare analyst wouldn’t know that?
  3. According to a number of media reports the chairman of VRX called select sell-side analysts after returning to the company after an illness last month, apparently to assure them that both he and the company were in robust health.  What’s wrong with that?  The purpose of Regulation FD, published by the SEC in 200, was to outlaw the selective dissemination of important company information (usually to favored brokerage house analysts) that most often occurred in phone calls like this.  Even if no sensitive information was disclosed in the VRX calls, they give the appearance of impropriety.  Why would any intelligent CEO do this?  Especially since…
  4. Last Tuesday, the company had a public conference call in which it sharply revised down its earnings guidance for 2016.  It also said it won’t be able to file its 2015 financials with the SEC on time, which will violate covenants on some of its debt.  That breach will allow the affected lenders to begin a process that could lead to default on those obligations–possibly meaning a demand for immediate repayment of principal.
  5. If media reports are correct, the predominant hedge fund reaction to the rollover in VRX stock has been to buy more rather than reduce their exposure (see point 1 for the reason why).

There may be a time for deep value investors to come in and try to pick up the pieces.  I don’t think we’re anywhere near that point, in time if nothing else, yet.



Ackman, Actavis, Allergan and Valeant

This is a situation I didn’t pay much attention to while it was going on but which I think has interesting implications for merger and acquisition activity in the future.  It doesn’t seem to me, however, that investors in general understand exactly what went on.

The bare bones:  Bill Ackman, of Pershing Square fame (and J C Penney infamy) bought just under 10% of Allergan, the maker of botox, and urged the company to put itself up for sale.  Ackman then allied himself with serial pharma acquirer Valeant to make a joint hostile (meaning against the wishes of the target) bid for Allergan.  Actavis, a third pharma company, emerged as a “white knight” to rescue Allergan from Valeant’s clutches with a bid that topped Valeant’s offer by about 15%.  Valeant conceded defeat.


This is the latest enactment of one of the oldest dramas on Wall Street.  A “black knight” makes a hostile bid for a vulnerable company.  The target firm, realizing that it is now in play, understands that at the end of the day it will most likely be acquired.  The only choice that remains to the target is to choose who the acquirer will be.  Invariably, it determines to join with anyone but the black knight that has caused all this trouble.  That’s why hostile bids fail as often as not.

For this reason, one of the bigger problems in the m&a game is that no one really wants to be the black knight.  Once the villain has appeared, however, there’s usually no trouble in finding someone willing to ride to the rescue.  In most cases there’s at least one potential acquirer hoping against hope that someone else will make the first move.


The Ackman innovation: in February, when he and Valeant became co-bidders for Allergan, he agreed to pay Valeant 15% of his Allergan profits if a third-party ended up acquiring Allergan.  This created a win-win situation for Valeant, which would either come away with Allergan or with several hundred million dollars for having played the black knight role.


–what was the Allergan price at which Valeant shifted from hoping to acquire the company to wanting to collect a fee from Ackman?;

— did Valeant ever really expect to own Allergan?;

–most important, will this maneuver work again?

I don’t know  …but the answer to question #3 depends a lot, I think, on the answer to #2.