A Preview of Sequoia's Coming Attractions

 Sequoia (SEQUX) has gradually transformed itself during the past decade. We've chronicled its evolution from one of the most concentrated equity funds into a more diversified offering. Ten years ago, the portfolio included just 15 stocks with more than 95% of assets in the fund's top 10 holdings--nearly a third in  Berkshire Hathaway (BRK.B) alone. A decade later, the number of holdings has tripled and the top 10 holdings claim just 52% of assets. It has gone from being easily one of the most concentrated funds to not even making the large-blend category's most-concentrated 10%.

Much of this transformation has occurred in the past three years. In mid-2009, the fund still had just 25 holdings. However, comanagers Bob Goldfarb and David Poppe have added 11 new stocks since June 2011 alone. These additions owe in part to the firm's aggressive analyst hiring. The staff has doubled since 2006, giving the team ample new capacity. Although the team follows a generalist model, several new hires bring expertise in technology, an area the fund had avoided in decades past.

The current impact of these new holdings, though, should be kept in perspective. Collectively, the 11 new positions account for just 8% of the September 2012 portfolio. However, these new stocks give important clues as to where the fund may be headed. Once Goldfarb and Poppe become comfortable with a company and its management, they will return to it when valuations become attractive.  Tiffany & Co. is a classic example. The team bought the stock in the second quarter, but the fund has owned the stock in the past, most recently in late 2006. Plus, when stock prices decline, the team often looks to add to existing holdings before buying new names. So, small positions today may eventually become significant parts of the portfolio.

The Next Generation
A natural concern in this case is whether quality is being sacrificed for quantity. Has the team lowered its standards in order to further diversify the portfolio? Although there are one or two curious cases among this new class, the overall answer appears to be no. Most of these companies appear to have the differentiated strategies and competitive advantages that the team prefers. As evidence, consider that Morningstar covers six of the 11 new additions, and each of the six has been assigned an economic moat by our equity analysts. Two firms ( Waters Corporation (WAT) and  Linear Technology ) have wide moats, and the rest narrow. This is in keeping with the broader portfolio. Roughly 90% of assets are invested in companies that, per Morningstar equity research, enjoy an economic moat.

Quality also shows in the return on assets for these companies. Goldfarb and Poppe place great emphasis on a company's and, by extension, its management's skill at allocating capital. A high ROA reflects well on the strength of the underlying business, but it also says something about management, especially when comparing a company with industry peers. Of the 11 new companies, all but three have a higher ROA than the September portfolio's 9.9% average, which itself is greater than the S&P 500 Index’s 8.7% average.

Common Family Traits
It should further reassure shareholders that many of the same traits and themes found in Sequoia's existing holdings are also common in this new crop. Most reflect the team's preference for capital-light companies that can earn attractive returns on capital. 

That capital-light thread runs through  World Fuel Services Corporation (INT), a top-25 holding first added in 2011's fourth quarter. Just as many shippers are looking to outsource their logistics to third parties, oil companies are interested in outsourcing their downstream delivery to an outfit like World Fuel Services. As with holding   Expeditors International (EXPD), it doesn't own much in the way of fixed assets. But what makes this a somewhat surprising candidate for the fund is that downstream fuel delivery is notoriously low-margin, which often goes hand in hand with low returns on capital. Indeed, that's why oil companies want out. WFS' operating margins, which haven't even cracked 2% in the past 10 years, bear that out. Its latest ROA is just 6.2%. What gives?

The team appears to be taking the long view of a consolidating industry. As more oil companies leave the downstream business, it opens the door to fewer competitors, increased growth and potentially higher margins. In the meantime, WFS can continue to strengthen its network as an aggregator or broker, providing the link between oil company supply and customer demand. In some ways, it's similar to the aggregator role played by clothing retailer and top 10 holding  TJX Companies (TJX). Once established, it becomes difficult for competitors to duplicate the access and relationships such firms enjoy.

What Are You Doing With My Money?
A corollary to the team's emphasis on capital-light companies is managements that don't waste money on unproductive research and development. This could be a concern with a holding such as  Google, Inc. (GOOG), which spent $5.2 billion on R&D in 2011. But this was still just 13.6% of sales. Historically, the most notorious R&D spendthrifts have been the big pharmaceutical companies. Although many have scaled back their ambitions, in their heyday R&D sometimes claimed more than 20% of revenue but often produced few marketable drugs. For this reason, the fund typically avoided such stocks. Sequoia's biggest current position,  Valeant Pharmaceuticals (VRX), chucked the traditional pharma model. Valeant would rather buy existing treatments and redistribute them than overspend on R&D. As a result, its R&D outlay is typically below 15% of revenue. Top-25 holding Novozymes caps R&D at 14% of revenue, helping it to an above-average 22% return on equity.

While it's easy to see the rationale for many of the fund's new additions, that's not to say all of them will work out. Even for a highly successful fund, there will be a few duds. Sequoia is still living down its out-of-character purchase of  First Solar (FSLR), which has fallen about 60% since it was first added in 2011's second quarter. But there are enough parallels between these new holdings and successful legacy positions for shareholders to feel the team is sticking to its process. Plus, considering that Sequoia boasts one of the category's best long-term records, the fund has earned the benefit of the doubt.