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By Kevin McDevitt, CFA and Jeremy Glaser | 03-29-2016 12:00 AM

Can Sequoia Recover From Its Valeant Stake?

There are many open questions surrounding Sequoia today, but Morningstar analyst Kevin McDevitt thinks the fund can move past its recent turmoil.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Sequoia Fund's large position in Valeant Pharmaceuticals has created a tumultuous period for the fund, capped off by the departure of long-term comanager Bob Goldfarb last week. I'm here today with Kevin McDevitt, he's a senior analyst at Morningstar and covers Sequoia for us, to talk about some of the changes at the fund and why we've downgraded it from Gold to Bronze. Kevin, thanks for joining me today.

Kevin McDevitt: Thanks for having me, Jeremy.

Glaser: We did recently lower our Analyst Rating from Gold to Bronze on Sequoia. That was following the departure of Bob Goldfarb, the long-term comanager there, and some other changes. Can you talk to us a little bit about some of the factors that led to this downgrade?

McDevitt: Sure. It's a combination of things. Certainly, Bob Goldfarb's resignation was part of that. Just despite the issues the fund has had, you're losing the most senior member of the team and someone who's been a comanager on the fund for 35, 36 years. So you're losing a lot of experience, you're losing a lot of institutional knowledge. And then you're also, to some extent, you're entering into a new era with David Poppe as the lead manager. And then you're also envisioning some changes to the strategy of the fund. I think these changes can be very positive, but they do introduce some uncertainty to the fund. And there are things we want to explore, we want to learn more about as time goes on, just exactly what these changes will mean for the fund strategy. To some extent, they are still being worked out by the fund itself, by David Poppe and his team, so it's somewhat of a work-in-progress at this point. So just kind of given a certain level of uncertainty about where the fund is going, although I think we know pretty well it's within fairly tight parameters. But still, there is some element of the unknown in terms of where the fund goes from here.

Glaser: Let's talk about those potential strategy changes. What would you expect from the fund going forward? Do you think they will be less concentrated?

McDevitt: Well, that's a great question, and it's somewhat of a tough question to answer. This I can say for sure: There will definitely be tighter risk controls than in the past, but as far as how those will manifest is not entirely clear, especially as it applies to concentration. What's interesting to me is before the Valeant stake got so big, the fund really was going in a direction. It really was going away from such heavy concentration. In the years prior to Valeant becoming the top holding, they had started to add more names to the portfolio. They were becoming more diversified. They had a bit less concentrated in the top 10 holdings, so that was a direction they were already going in. So I think Valeant became an anomaly, just that it got so big. It took them in a direction they weren't really contemplating. So that's the roundabout way of saying I think it will be a bit less concentrated, but then again, I think they've always seen concentration as a key to their outperformance over the long term, and the fund still does have a very strong long-term record. I think it's more just a matter of risk management. I think it'll be a matter of the fund will still be concentrated, but I doubt you'll ever see it to the extent you saw with Valeant. But you'll still see a lot of concentration, I think, in those top five names in particular.

Glaser: So what is being done on the risk management side to prevent another Valeant from happening?

McDevitt: Well, that's, again, kind of an open question. I think it's something that they are working out internally as we speak. I think it will mean more of a change in decision-making. David Poppe, again, the lead manager now, is going to set up an investment committee that will consist of himself and three other senior analysts. Basically, the idea is to avoid a situation where you have one person making decisions for the whole portfolio and having a situation where that one person could drive a position, like we had with Valeant, and he has very centralized decision-making. They want to decentralize the investment process, have more voices heard, and avoid situations where it's just one person pushing for this one large position. I think, again, you'll avoid a Valeant-type situation in that sense going forward. Again, as far as the other risk management issues, one of the things David Poppe has mentioned is they're less likely to hold or own firms that have as much debt as Valeant has. Again, that was always out of character to some extent, and I think you're even less inclined to see such indebted firms in the portfolio, at least in such heavy concentration going forward.

Glaser: Sticking on Valeant for a moment. Are there still risks? Are they still big holders of the company? Are there still risks to the fund from Valeant today?

McDevitt: Yeah, I think for the time being, there are, although I think that could very easily change. At this point, I think they still own about 6.5... Or I should say Valeant still represents about 6.5% of the portfolio. But again, I think that could very easily change. I'm not predicting it will or I'm not saying it will, I have no knowledge of that. But given that Bob Goldfarb is no longer there... And they also, too, just announced that the senior analyst, the lead analyst on Valeant, also has left the firm. So between Bob Goldfarb leaving, the lead champion of the position, and then the lead analyst leaving the firm, there's no one really there to champion Valeant. So I think again, you can imagine a scenario in which they do sell the position entirely. But again, that's... I'm not predicting that, but I think that's possible.

Glaser: And then how about outflows? Certainly, investors have been concerned about this Valeant position. Are there any worries about liquidity? Will they be able to meet these outflows?

McDevitt: Yeah, I think there are... It's something they certainly need to manage. I wouldn't necessarily say that's something we're worried about, but it's going to be a challenge for the fund for I think for the rest of this year at least, I would guess. They just announced that, or I should say Morningstar just estimated that it had over $400 million, the fund has had over $400 million in outflows so this year. They did sell about 1.5 million Valeant shares about two weeks ago to create some more liquidity for the fund, and this gave the fund a bit of a buffer. And I estimated that at the time, the fund had about 14.5% of its assets in cash, which again, gives it a decent buffer, but you still have significant outflows. So I think they're going to continue to need, if they want to stay ahead of the redemption, stay ahead of the outflows, they're going to need to continue to reduce positions and reduce other, sell shares in other positions to maintain a comfortable liquidity level.

Glaser: The fund was downgraded, but it's still a medalist, it's still a Bronze medalist, which means that we have confidence that it will outperform its category over time. How do we still have this confidence with these open questions around it and with some of the other concerns surrounding the fund?

McDevitt: Sure. I would point to several things. One is the fund still, despite all the issues it's had with Valeant, still has a very strong long-term record. And if you're going back 15 years, let's say, the fund is still in the top decile of its category. And it's worth pointing out, too, that lead manager David Poppe was there for all of that. He has only been comanager for the last 10 years, but he's been with the firm since 1999. And he, again, was the handpicked successor to Bill Ruane. So we have a lot of confidence in David Poppe. And then also, too, he's got a very strong team around him. He has a number of senior analysts who've been at the firm for years and years. And again, I think they're also ready to step up into more leadership-oriented roles.

I would also point out, too, there is uncertainty and that did factor into the rating, but the uncertainty is more in the sense that there are going to be tighter risk controls on the fund going forward; the uncertainty is just not knowing exactly what those are going to look like. And also acknowledging, too, that although I think the fund will be more risk-conscious going forward, the bottom line is that having that a very concentrated portfolio is one of the reasons why the fund was able to outperform the way it did for years, over the very long term. So it's an acknowledgment that there is that uncertainty, but it's not uncertainty in the sense of it will mean greater risk for the fund. That is not what is going to happen. This will be, I think, a less risky, less aggressive fund going forward.

Glaser: So when you think about either Sequoia or other more concentrated stock funds, how do you suggest investors really use these in their portfolios? Does this make sense as a core holding? Is it more of a satellite holding? What's the best way to use a fund like this?

McDevitt: That's a great question and I think one that's not, frankly, that's not asked often enough. This is definitely a satellite holding, and really, to your point, all concentrated funds, in my opinion, should be satellite holdings. They should not be core holdings. For this reason, that there's always this potential for positions to blow up, for things to not go well, and you can have such an outsized impact on the fund from just one or two holdings. So I think concentrated funds certainly have their place in a portfolio, but, again, I think they're almost always better off as satellite holdings there for diversification, or if you're an active investor and looking for another source of alpha. But again, these should not be core positions in your portfolio.

Glaser: Kevin, I really appreciate the update on Sequoia Fund today.

McDevitt: Yeah. Thank you, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.

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