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Rediscovered: How Sequoia Cranks Out Good Returns

If you're harboring doubts about Sequoia Fund's reopening, cast them aside. It's still a great mutual fund.

Michael Breen, 08/04/2008

First a Led Zeppelin reunion show. Then kids start wearing Chuck Taylor Hi-Tops again. And now the Sequoia Fund reopens to investors. The old school is officially back in session.

I confess: I'm lukewarm on the first two items but excited by the third. Here's why. Sequoia, run by advisor Ruane, Cunniff & Goldfarb, has a four-decade-long record of success and remains a pillar of value investing. But it has been closed for a quarter century. Now we can finally buy it.

Good Genes
The fund's lineage is impeccable. Bill Ruane and Richard Cunniff started Sequoia in 1970, mostly as a vehicle to absorb investors sent over by none other than Warren Buffett, who was folding his investment partnership. Even then, the future Oracle of Omaha knew his stuff. Ruane and Cunniff shared Graham-inspired value underpinnings with Buffett. They were also strong investors and conscientious stewards. Their new fund got off to a slow start, but it hit its stride in the mid-1970s, racking up big gains in six straight calendar years and trouncing the relevant benchmarks. Money cascaded in, and the duo closed the fund in 1982. It stayed shuttered, despite a relatively puny asset base that later peaked at just $6 billion. The managers didn't want inflows forcing their hand or diluting existing shareholders.

Ruane and Cunniff were also great teachers. They groomed a generation of investors who still benefit the fund today. Current manager Bob Goldfarb is a prime example. In 1975, with a nudge from his father who had correctly pegged Ruane and Cunniff as men who lived the investment process and weren't get-rich-quick schemers, Goldfarb joined the firm. He eventually became Sequoia's manager and the advisor's president. Goldfarb is far from the only lifer at the firm. Analyst Greg Alexander, for example, has been at the firm since 1985, and many of his colleagues have been in-house for more than a decade.

And everyone eats their own cooking at Sequoia. Ruane and Cunniff strongly encouraged employee ownership, making significant stock transfers to the troops on favorable terms. Goldfarb is a top shareholder in the advisory firm, as are all the firm's investment professionals. In turn, the advisor owns a big chunk of the fund.

No Secret Sauce
Outstanding implementation of a straight-forward process is Sequoia's hallmark. Simply put, the team executes better than nearly everyone else. Chatting with Goldfarb reminded me that Sequoia usually makes its money buying proven firms that are hiding in plain sight. This isn't cigar-butt investing. Goldfarb and his team don't bet on struggling firms with uncertain futures or on flavor-of-the-month newbies. Rather, they focus on understandable businesses that consistently generate strong returns on equity. Passionate managers with skin in the game are icing on the cake. That's it. Like Buffett, the Sequoia team's preferred holding period is forever.

Take longtime holding Fastenal FAST. It's in the unsexy business of supplying commercial and industrial fasteners. But the firm dominates its niche with an expansive distribution network and focused salesforce. It has achieved the impressive double dip of strong revenue growth coupled with improving margins. It consistently generates returns on equity north of 20% off a debt-free balance sheet. Fastenal has always traded at a steep premium to the overall market, but that didn't scare Goldfarb and his team when they grabbed it in 2001. The stock has hit peaks and valleys over the years, but Sequoia doesn't dump fine businesses. Fastenal has returned an average of more than 20% annually since Sequoia first bought it. The best news? Goldfarb says Fastenal has plenty of runway in front of it. The firm has less than 10% market share in a fragmented sector and is ramping up its overseas operations.

Sowing New Seeds
Two recent picks highlight the meaty analysis and patience that set the Sequoia team apart.

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