Sequoia Fund Symbolizes What Was, But No Longer Is

Old School

You've probably heard about

(The Morningstar equity analyst covering Valeant estimates its fair value to be $115 per share, albeit with so much uncertainty that the Consider Buying price is far lower, at $57.50. Valeant’s current stock price, at the time of writing: $37. Hmmm.)

In many respects, Sequoia’s swoon represents the passing of an era. The fund was born at a very different time, when index funds had not yet been invented, and when many more investment managers were the exception to the general rule of market efficiency. Upon closing his partnership, Warren Buffett recommended as a substitute the newly created Sequoia Fund, comanaged by his longtime friend, Bill Ruane. Sequoia repaid Buffett’s faith with four decades of above-market returns. As other actively managed funds fell, Sequoia kept performing. It was, perhaps, the last man standing.

(One can quarrel with that final sentence. Bill Nygren’s

Convicted by Conviction The fund's concentrated approach was from a different time as well. Back in the day, before it became fashionable to measure funds by their relative performance to benchmarks and by risk-adjusted performance, portfolio managers were expected to demonstrate their "conviction" by holding large amounts of their favorite securities. The Investment Company Act of 1940 permitted the creation of "non-diversified" funds to accommodate the needs of fund managers who felt restrained by the customary limit of 5% in a single position. Sequoia was one such non-diversified fund. Few such funds are launched in today's more-cautious climate.

As a lone wolf, Sequoia also has diverged from the pack. Sequoia was founded at a time when investment managers liked to state, “We only try to do one thing, but we do it very well” and “We put all our eggs into one basket, and then watch that basket very closely.” (The latter is often credited to Warren Buffett. That illustrates the fame that comes from making several dozen billion dollars--because that adage was old when The Oracle of Omaha was the Infant of Omaha.) Management resisted launching additional funds, resisted becoming a mutual fund complex. It treated Sequoia’s shareholders as if they were partners.

That, in many respects, is a good thing. Jack Bogle has long argued that fund companies cannot serve two masters. They cannot fulfill their duties to their funds’ shareholders while simultaneously satisfying the needs of those who own stock in the fund company itself (or who expect that fund company, as the division of a larger company, to generate steadily increasing profits). Thus, states Bogle, a partnership structure is attractive. I tend to agree with that, but the question arises if, in this day and age, the resources available to single-fund partnerships are sufficient for the task. The Sequoia example does not encourage.

The Passing of the Torch The mutual fund industry has swapped Clint Eastwood for the Texas Rangers. Today's funds are not managed by the strong, silent man who has the courage of his convictions, who relies only on his own counsel, and who dares to go where others do not tread. They are instead products of organizations, checked and balanced by risk committees, quantitative analysts, and senior management. Increasingly, the management structure uses not a single lead portfolio manager, nor even dual managers, but instead multiple investment professionals. The cottage has become an office park.

That Sequoia's stumble came because of Valeant, a security that had been publicly cited as exemplifying the harmful, distorting effects of index investing--because, the story went, Valeant as a Canadian company was not selected for the S&P 500, and thus the stock languished because it was neglected by S&P 500 funds that were putting their cash to work--completes the picture. What better symbol of active management's overconfidence than the leading actively run fund being sunk by a stock that was called indexing's mistake? The good ship Active, it appears, ran aground on the rock of hubris.

From Bad The Chicago Cubs and Chicago White Sox each won their first two games of the 2016 season. (The Sox then broke the streak by losing Game 3 to the Athletics.) As four coin flips would randomly land as all heads in one coin-flipping sequence out of 16, and during the previous 54 years the Cubs and Sox had failed to win those four combined games, that would be anecdotal evidence to support the thesis that Chicago baseball ... is bad.

But how bad, I wondered? If Chicago baseball teams had a 50% chance of winning, what are the odds that a 54-year dry spell would occur by chance? It turns out that the answer is 3%. Better than I expected. But I’m still sticking with my original belief. Chicago baseball is bad.

To Worse The embattled general manager of the Philadelphia 76ers, Sam Hinkie, tendered his resignation letter this Wednesday. A better example of investment-manager humblebrag you will never encounter. (Prior to working in sports management, Hinkie was an investment manager.) In 13 pages, Hinkie delivers a "healthy dose of self-flagellation about things I've done wrong," by telling us how deeply misunderstood his mostly correct decisions have been.

The letter begins with Hinkie comparing himself to a 38-year-old Warren Buffett; he then opts to “stand on the shoulders of Charlie Munger” on Page 2, and he cites Elon Musk and James Clerk Maxwell at the top of Page 3.

At that point, I began to skim. Your breaking point may come later. In fact, as you have demonstrated the patience to finish this column, it very likely will. Thanks for reading!

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.