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Sequoia Dials Down Its Concentration

This venerable fund has made some changes to its portfolio, but it's still fabulous.

Bridget B. Hughes, 12/01/2010

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Sequoia SEQUX is selling Berkshire Hathaway BRK.A, but that's not the only news here.

The fund's most recent semiannual report shows that, as of June 30, 2010, Berkshire Hathaway accounts for 12.4% of assets. That still makes it the concentrated fund's top holding by more than 5 percentage points, but it's a far cry from the 35% position it once held.

The reduction has been gradual, taking place over the course of roughly the past five years. Sequoia is among the most deliberate and methodical funds out there when it makes changes to its portfolio. It's never in a hurry, as attested by its consistently low turnover, which is regularly below 15% a year.

Berkshire Plays a Lesser Role
Berkshire Hathaway, Warren Buffett's investment company, has been linked to Sequoia for 30 years. There's a personal attachment: When Buffett first closed down his own investment partnership in the late 1960s, he recommended investors seek out fellow Benjamin Graham-style investor and friend Bill Ruane, who launched Sequoia in 1970 with his partner, Richard Cunniff.

That said, it's not as if Sequoia has always made as big a commitment to Berkshire as it has in the past 15 years. The fund didn't own the shares until 1990, and at first it made up a smaller piece of the portfolio. And it wasn't until the third quarter of 1992 that it took up more than 15% of assets.

Today, managers Bob Goldfarb and David Poppe still like Berkshire. Many of the attributes they seek in a long-term investment, such as a rock-solid balance sheet and an ability to compound capital, remain intact, and they said in their 2009 annual report that they expect double-digit annual earnings growth in 2010 and 2011. But there are several reasons for trimming the stock. Goldfarb says he can find cheaper stocks. In addition, it's unlikely Buffett's successor will be as good as he is. Finally, Goldfarb says they want a flatter, more diversified portfolio.PAGEBREAK

The Portfolio Spreads Out
Goldfarb and Poppe have further diversified the fund by increasing the number of stocks in the portfolio. As of the end of June 2010, Sequoia owned 36 stocks. That's double what the fund held 10 years ago. Further, whereas more than 80% of assets were parked in the fund's top 10 stocks early in the 2000s, roughly half the fund's assets rest in its 10 largest holdings today.

True, some old favorites remain at the top of the heap in a big way. Retailer TJX Companies TJX (6.9% of assets) has been part of the fund since late 2000. And even though management said at its Investor Day in mid-May 2010 that Fastenal FAST, which the fund has held since late 2001, was trading at a "very high multiple," the stock still accounts for 5.8% of assets because Goldfarb and Poppe appreciate that it has continued to grow sales at a fast clip. Generally, the fund still puts a heavy emphasis on five or six names.

Still, there are several new names in the fund--one of which has become a quick favorite. Goldfarb and Poppe bought Valeant Pharmaceuticals VRX in 2010's second quarter (before the company's June 21 announcement of merger plans with Biovail). At the end of June 2010 (nine days and 14.4% appreciation after the merger announcement), Valeant took up 5.7% of assets. It's up roughly 25% since then, and Goldfarb and Poppe are hanging on because they like Valeant's CEO and, importantly, his proven record of smart capital allocation.

Sequoia bought six other new names in 2010's second quarter, though they're each a much smaller piece of the portfolio, at least for now. Johnson & Johnson JNJ, for example, fits nicely in Goldfarb and Poppe's strategy. It is one of the few pharmaceutical firms to hold an AAA credit rating; it consistently generates prodigious free cash flow (which it uses to support its dividend and R&D budget and to make acquisitions, which can spur revenue and earnings growth); and, by many accounts, it is trading at a meaningful discount to its intrinsic value, especially after falling from its April 2010 highs. Other new holdings include IBM IBM, Goldman Sachs GS, Google GOOG, QinetiQ Group PLC QNTQY, and Trimble Navigation TRMB.

Cash Is Back
While Sequoia has been decreasing its Berkshire stake and spreading out the fund's assets, cash has been climbing. At 20.6% of assets at the end of June 2010, it has reached its highest level since the early 2000s.

Despite new attractive opportunities, there have been some other sales that have added to the cash hoard. For example, Goldfarb and Poppe sold Martin Marietta MLM, which took up 4% of assets at the end of 2009, during the first four and a half months of 2010. At Sequoia's Investor Day, Goldfarb said the investment team had bought it "too high" (in 2007's second quarter and likely fairly close to its 10-year high). Chase Sheridan, a member of the investment team, worried about public-infrastructure spending as well as overcapacity in the aggregates industry despite Martin Marietta's pricing power.

No Worse for the Wear
While these shifts meant the fund's standard deviation, a measure of volatility, did increase throughout the past decade, it remained less volatile than its benchmark, the S&P 500 Index. (Not surprisingly, as cash has subsequently risen, its standard deviation is trending back down.)

Further, its performance hasn't changed. It held up well during 2008's harsh sell-off (though it still lost 27%) and limped behind its peers and the index in 2009's rally, albeit with a healthy 15% gain. All told, the fund's long-term returns remain topnotch from both absolute and relative angles: Its 15-year annualized return is 9.6%, which lands it well in the large-blend category's best decile.

Potential for a Category Change and Closing
There are two other points of interest. With Berkshire less of a driver here, it's possible Sequoia could move into the large-growth category. Top holdings such as Idexx Laboratories IDXX, Fastenal, and MasterCard MA already skew the fund right; the addition of companies such as Valeant and Google further the effect. This preference for faster-growing companies is hardly new for the fund but may have been masked by Berkshire's prominence. Thus, a category change, if one indeed comes, wouldn't signal a real change in investment approach.

Finally, to the extent that cash continues to rise--or even just stays at current levels--the fund could close its doors again. That risk increases if and when stock valuations move higher and the managers see fewer attractive investment options. Investors who have admired the fund from afar may want to consider buying now.

Bridget B. Hughes, CFA, is an associate director of fund analysis with Morningstar.

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