Sequoia's Robert Goldfarb and David Poppe are seeking a firm with as much earnings potential at a low price as Buffett's company 20 years ago, but they note the outcome is unlikely.
Robert Goldfarb and David Poppe, presidents of Ruane, Cunniff & Goldfarb and portfolio managers of Sequoia SEQUX, recently answered our questions on the virtues of a concentrated portfolio, the challenges that pharmaceutical companies will continue to face in light of government fiscal problems, and how proper long-term company analyses can lead to exceptional investments. They also stated that the universe of quality businesses has moved away from its all-time lows and discussed specific opportunities currently found in the retail sector.
1. You steered the portfolio away from a high concentration effort to a more diversified approach. What led you to this strategy change? Are you concerned that a more diversified approach could potentially dilute the portfolio?
We still believe strongly in the virtues of concentration. The best way to outperform an index of stocks is to own a concentrated portfolio of great businesses purchased at reasonable valuations. Our views on this subject haven't changed in 40 years. If you exclude Berkshire Hathaway BRK.A BRK.B, our concentration in our next five largest holdings is as high today as it has been through most of our history. But we came to view a 30% weighting in Berkshire Hathaway as inappropriate, largely because of Warren Buffett's acknowledgement that the law of large numbers would cause Berkshire's rate of earnings growth to slow materially in the future. We were fortunate to be able to reduce Berkshire to 12% in 2010 through two significant sales at reasonable prices when the company entered the Standard & Poor's 500 Index and the Russell 2000 Index, which forced index funds to buy the stock irrespective of price. Our current weighting in Berkshire is slightly more than 10%. Because Berkshire is selling at the same price at which we sold it nearly two years ago and Warren Buffett has significantly increased the company's intrinsic value through massive deployment of capital, we are extremely comfortable with this weighting and with Berkshire's prospects.
This has been a managed transition for Sequoia. In anticipation of one day owning less Berkshire, we hired a number of outstanding analysts during a period of several years. This new team has allowed us to analyze and purchase more businesses with the characteristics we have always liked. All the proceeds of our Berkshire sales were fully redeployed in new ideas. As long as these new businesses are as attractive as the ones we own and have the same price-value relationships, they should not dilute the performance of the portfolio. We would be nearly fully invested today had not we experienced a net inflow of more than $900 million in 2011, which we did not anticipate. We would love to find an earnings compounding machine as attractively priced as Berkshire was in 1990 and let it grow to a 30% weighting of Sequoia, but we view such a prospect as unlikely.
2. When you spoke to us during the summer, you mentioned that you didn't like the traditional Big Pharma companies because of the high reimbursement risk associated with them. Has this thesis remained the same? Why or why not?
The intensifying fiscal problems of governments in the United States and Europe have only reinforced our belief that pharmaceutical companies will face more challenging reimbursement issues in the years ahead.
3. Given today's environment, are there any areas that you're staying away from and plan on staying away from in the near term? Why? On the flip side, for what areas do you have the most enthusiasm?
We think of ourselves as item buyers. We are always trying to find the next great business, and we don't spend much time contemplating sector exposure. As long-term investors, we are not averse to looking hard and buying a terrific company selling at a reasonable price because its short-term outlook may cause others to stay away. The key is getting the long-term analysis right. A strong company in a disfavored sector can make for a great investment.
4. Do you think that quality is still selling at all-time lows?
We don't think quality is selling at all-time lows. We own a number of very high-quality businesses that sell at or close to all-time highs. It may be fair to say that some high-quality mega-caps, cyclicals, financials, and companies with heavy exposure to Europe have been marked down, but the universe of quality businesses is not uniformly cheap.
5. What opportunities are you finding in the retail sector?
We like the retailers we own but have a policy of not commenting on prospective investments. Of the retailers we own, TJX Companies TJX, Target TGT, Wal-Mart Stores WMT, and Costco Wholesale COST offer remarkable savings to consumers and seem well-positioned for the current economic times. O'Reilly Automotive ORLY and Advance Auto Parts AAP benefit from the aging of the U.S. auto fleet and the importance of inventory availability in automotive hard parts. They carry an essential, yet specialized offering that consumers tend to need in an emergency. If you want to drive the car, you must buy the part. Discounters and Internet retailers cannot readily compete in a business that requires immediate availability of massive numbers of slow-turning parts, which has the effect of protecting high margins for the few players that can earn a reasonable return on the inventory investment.