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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.

In late 2007, the fund picked up Rolls Royce, a British firm known for its defense operations and marine and commercial power systems. But Goldfarb says that the firm's civil-aviation segment is an underappreciated asset. It operates in a virtual duopoly with General Electric GE. The clear number-two player, Rolls Royce still has a strong and improving business. Surging demand from Asia and the Mideast has bolstered an already-substantial order backlog, which will continue driving revenues. Rolls Royce has already swallowed a huge set of initial costs, so margin improvement should be forthcoming. And most important, according to Goldfarb, is the annuity stream of income the firm is creating from the long-term parts and maintenance contracts it's signing on top of its new engine sales.

Then there's Whole Foods Markets WFMI. When I asked Goldfarb about the firm, he spoke extemporaneously and in impressive detail about its operations for 30 minutes. He says the specialty grocer is facing several near-term issues but remains a strong franchise. He itemized how it's digesting heavy costs from its acquisition of Wild Oats, battling rising preopening costs on its new stores, and dealing with contracting demand caused by a dodgy economy. He sees the first two items improving in 2009 and says that the firm has huge growth opportunities in the United States and does not need to rush overseas. Goldfarb's thorough knowledge of this holding is all the more impressive considering that it accounts for just 1% of Sequoia's assets.

Biggest Risk: It Will Close Again
Concerns have been raised since Sequoia reopened, but they're not cause for worry.PAGEBREAK

First, a few observers think the fund has lost a step since Ruane and Cunniff stopped running the operation. (Ruane passed away in 2005, and Cunniff remains on the fund's board.) Not true. Sequoia has crushed the S&P 500 Index and 80% of its category rivals in the decade since Goldfarb took over as lead manager.

Second, some have speculated that the advisor reopened the fund to gather assets before putting itself for sale. Nothing could be further from the truth. Goldfarb says that they wouldn't sell at any price. We believe him. Sequoia reopened to refresh a shareholder base that was aging and suffering from some attrition. This firm has never been about grabbing assets. It runs about $16 billion firmwide--a nice chunk of change but a blip on the radar screens of such like-minded boutiques as Davis Advisors and Dodge & Cox. In fact, the bigger risk to interested investors is the fund closing again if new money rushes in too quickly. Goldfarb say that he won't dilute existing shareholders by sitting on new cash if he can't put it to work.

Finally, there is a big tax overhang to keep an eye on. It comes with the territory. Successful investors with low portfolio turnover have big unrealized capital gains exposure. Sequoia's now sits north of 40% of assets, and the fund has been upfront in warning potential new investors about it. We don't have a crystal ball, but we're comfortable that those buying into the fund now won't get poleaxed by the tax man in 2008. The fund has been taking some gains lately, but those look to be almost exclusively long-term. The fund's turnover rate is also glacial, and its managers have always done a solid job minimizing taxes. And, most importantly, the fund's principals are its biggest shareholders, so increased taxes would bite them the hardest.

Michael Breen is a senior mutual fund analyst with Morningstar.

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