The fund is more diversified than in years past, but no less focused on quality and the long term.
Sequoia (SEQUX) has significantly diversified its portfolio over the past six years after David Poppe joined Bob Goldfarb as comanager in 2005. We've written about that before, but spreading the fund's branches hasn't weakened its trunk.
During that time, the number of stocks in the portfolio has nearly doubled to 34. In 2005, Berkshire Hathaway (BRK.A) and Progressive (PGR) absorbed about half the portfolio's equity assets. Today, Progressive is gone and Berkshire is down to about 10% of assets.
While the portfolio has certainly changed since 2005, the traits that Goldfarb and Poppe look for in companies are largely the same, although with a few small tweaks. They still prize companies with sustainable competitive advantages and talented management teams that are effective capital allocators.
Sustainable Competitive Advantage
A lot of managers say that they are looking for companies with competitive advantages, but few actually follow through completely. Sequoia is one of the few that does. It shows most clearly in the fund's sector weightings, where it has little exposure to commodity-type businesses, or those where it is very difficult to create or sustain a competitive advantage. Note that the fund has hardly any positions in basic materials, energy, communications, or utilities. Few companies in these sectors have strong brands or franchises that allow them to generate higher than average profit margins.
That has traditionally been true in technology as well, a sector that the fund had long avoided. But in recent years, the fund has added several technology stocks, most notably Google (GOOG) and IBM (IBM) in 2010. The team added Google because it views it as more of a marketing company than a technology one, although it also believes that Google has an insurmountable advantage in search technology. Microsoft (MSFT), on the other hand, a current darling of some value managers, has spent billions taking a run at it and has met with little success, at least in terms of actually making money.
In IBM's case, the competitive edge is perhaps less obvious, as it owes to the company's combined expertise in software, hardware, and services and because it offers enterprise solutions to big companies. More important to Sequoia, though, was an IBM trait that's rare to find in technology.
Especially in companies that generate a lot of cash flow, Goldfarb and Poppe pay close attention to how they allocate capital. Do they reinvest in profitable projects and promising research and development, or do they blow it by overpaying for questionable acquisitions? IBM spends billions a year on R&D, but this has ultimately paid off in consistently strong profitability. On the other hand, the team worries about Google, which could get distracted spending money on unrelated projects such as cars that drive themselves. Microsoft is another example of a company with ample free cash flow but that has struggled for years to spend it profitably.
This issue is also endemic in health care, particularly with the big pharmaceutical companies. These also tend to be favorites of value managers, but Goldfarb and Poppe generally avoid them. That's because Big Pharma has a horrible track record at turning billions in R&D spending into marketable treatments.
Sequoia does have about twice the S&P 500 Index's exposure to health care, but none of it is in traditional Big Pharma. Top-holding Valeant Pharmaceuticals (VRX) spends little on R&D. Instead, it buys mature or niche drugs that it can market through its ample distribution network.
Betting on the Jockey, Not the Horse
What initially attracted the team to Valeant, though, was the firm's relatively new CEO Michael Pearson. Goldfarb and Poppe were impressed by Pearson's disciplined approach to capital allocation and the way he focused on profitable, niche opportunities. Such faith in management shows a subtle shift in how the team approaches potential investments these days. In somewhat of a break with Warren Buffett's approach, Goldfarb and Poppe have placed increased importance on management in recent years. Buffett has long believed that the quality of the underlying business was more important than the jockey. He believes that there's only so much a management team can do to overcome the economics of the industry in which it operates.
While Goldfarb and Poppe likely wouldn't disagree with this premise to a great extent, they do believe that smart management teams will find some way to add value. That belief was part of the reason the fund bought shares in oil and gas company Canadian Natural Resources (CNQ) in early 2009. Canadian Natural Resources has access to tremendous oil resources in Canada and is in the fairly unusual position of being able to increase its production, which is a problem for many of the oil majors. But Goldfarb and Poppe were also attracted to CEO Murray Edwards' smarts and skill as an asset allocator.
Once they've added such a company to the portfolio, the duo is reluctant to sell, even as valuation multiples climb. This shows in both the fund's low turnover, which is typically well below 25%, and in the portfolio's average price multiples. Although the team is very disciplined about buying a stock at the right price, it will happily hold on to shares as the price multiples expand.
That explains the fund's above-average multiples relative to large-blend funds, which have actually kept it in large-growth territory now for years. Rather than having valuation drive the decision whether to sell, Poppe says that changes in a company's competitive position are usually the catalyst. With that said, the team has reduced its position in veterinary diagnostic company Idexx Laboratories (IDXX) in recent quarters in part because of valuation and also because of the fact that the stock had become 8% of the portfolio. However, the team also acknowledges that customers have been less willing to spend money on their pets in this difficult economic environment.
The managers have assembled an impressive collection of companies here, which should give shareholders reassurance during the next bear market. It has close to a fourth of its assets in cash, which reflects the team's belief that while valuations in general are reasonable, there are not many screaming buys these days. Poppe, in particular, believes earnings growth for U.S. companies could be anemic in years to come once the Federal government removes various stimulus measures. Investors here can feel good about the fact that the team has the dry powder to take advantage of opportunities as they arise.