Sequoia's Foundation Looks Stronger Than It Was Before

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The leveling wind has been brutal, but Sequoia's extensive remodeling efforts should bear fruit over time. For that reason, its Morningstar Analyst Rating remains Bronze.

The portfolio finally sold former top holding

As painful as that stretch was, the fund's foundation looks stronger than before, thanks to new risk controls and a more robust process. While the fund remains highly concentrated, it now caps position sizes at 20% of assets, with those greater than 10% of assets receiving greater scrutiny and more-frequent formal reviews. Plus, no one person on the five-person investment committee can override the majority.

However, the fund may be more volatile than it had been in the past. The team believes cash has been the other culprit in the fund's underperformance over the past decade. As a result, it plans to keep cash below the fund's historical range of 15%-20% of assets, with the goal of being closer to fully invested, although cash was 9.8% of assets at the end of 2016. While cash may have hurt returns during rallies, it provided a buffer during downturns. Furthermore, less cash might eventually force the team to sell equity shares if outflows continue. The fund has endured $1.9 billion in outflows over the past 12 months alone.

Nevertheless, the team, led by David Poppe, remains exceptional. Plus, despite the outflows, the firm continues to invest in its team, hiring two new analysts in January. As dark as things were over the past 18 months, this fund looks well-positioned for the future.

Process Pillar: Positive | Kevin McDevitt, CFA 02/10/2017 This team takes a Warren Buffettesque approach. It prizes companies with sustainable competitive advantages and management teams that allocate capital effectively. The portfolio is quite concentrated with 25-35 stocks, reflecting the team's belief that it is better to invest heavily in a handful of its best ideas than dilute the portfolio. When it finds a talented capital allocator, it is reluctant to sell shares, even though this can lead to high price multiples in the portfolio and can create significant short-term volatility.

However, the fund introduced new risk measures after its disastrous experience with Valeant Pharmaceuticals. Beginning in April 2016, the fund caps position size at 20% of assets. Furthermore, the team formally reviews positions as they grow beyond 10% of assets. (As of December 2016,

While individual positions may not grow as large as in the past, the team also plans to hold less cash than it has historically, which was often 15%-20% of assets when valuations looked stretched. It found that the fund’s stock picks excluding cash have performed better over time than the portfolio including cash. So, cash will likely be below 10% or so going forward, which could make the fund more volatile than in the past.

This fund's portfolio looks far different from one year ago. Management sold its final Valeant Pharmaceuticals VRX shares in 2016's second quarter. By year-end 2016, longtime holding Berkshire Hathaway was back in the top spot with a 16.7% weighting. Cash was just below 10% of assets, below the historical average. The team also sold many of its smaller positions, taking the number of holdings to 27 from 44 two years prior.

Once management has added a stock, it is reluctant to sell. This shows not only in the fund's low turnover, which is usually well below 25%, but also in its 2013 move to the large-growth Morningstar Category because of average price multiples greater than the S&P 500's. Sell decisions tend to be driven more by changes in a firm's competitive advantages than its valuation.

The fund typically avoids commodity-oriented businesses, and this shows in its sector weightings. The fund has minimal exposure to basic materials, energy, communications, or utilities, as it is difficult to create a competitive advantage in these sectors. Instead, the fund has more than half the portfolio in industrials, consumer discretionary, and healthcare stocks. The portfolio’s 25.6% discretionary weighting is more than twice the S&P 500’s. Companies in these sectors often have stronger business franchises and some pricing power. Its 21.5% financials stake is 50% greater than the index's.

Performance Pillar: Neutral | Kevin McDevitt, CFA 02/10/2017 Valeant Pharmaceuticals eviscerated this fund's record. From Valeant's peak on Aug. 5, 2015, when it accounted for more than 28.7% of assets, it fell 92% through June 2016. At the 2015 peak, the fund's 11% annualized 10-year return was a mighty 3.3 percentage points better than the S&P 500's. Less than 12 months later, its 5.9% 10-year return trailed the S&P 500 by nearly 1.5 percentage points.

Results have improved a bit since the fund banished Valeant in 2016's second quarter, but its 10.1% return for the seven months through January 2017 still lagged the S&P by 1.3 percentage points. So, even the fund's 6.4% 15-year return lagged the index by 0.5 percentage points annualized. But the fund's risk-adjusted results match the index over that period, keeping the fund's Performance rating at Neutral. Recall that this wasn't the first time that the fund's top holding fell flat. The fund hit rock-bottom in 1999 when it lost 16.5% largely because of the poor performance of then-top holding Berkshire Hathaway.

Historically, the fund's large cash holdings and concentrated portfolio led to fairly uncorrelated risks with the market. Over the past 15 years, the fund has an R-squared of just 54 relative to the S&P 500 versus 93 for its typical large-growth peer. Given that management plans to hold less cash going forward, the fund may be more volatile and less resilient during downturns. On the other hand, this may lead to better results during rallies.

People Pillar: Positive | Kevin McDevitt, CFA 02/10/2017 David Poppe is the sole portfolio manager after longtime manager Bob Goldfarb resigned in March 2016. Poppe has been a manager since 2005 and has been with the firm since 1999. Poppe is only 51 years old and has more than $1 million invested in the fund.

In May 2016, the firm created an investment committee, which includes Poppe and senior analysts Arman Gokgol-Kline, David (Chase) Sheridan, and Trevor Magyar, as well as John Harris and Greg Alexander; Alexander is a nonvoting member of the committee. Harris and Alexander are not actively involved in managing the fund as they run their own separate private portfolios. But they both bring extensive experience and expertise to the committee. This wealth of resources earns the fund a Positive People Pillar rating.

Poppe is its sole portfolio manager, but the investment committee can overrule him. Whereas Goldfarb used to have final say, the other four voting members could block a buy/sell decision if there was disagreement. This ensures that no one person can overrule the rest of the team.

Even with heavy outflows over the past two years, the firm has invested in the team. It has 12 dedicated investment professionals: Poppe, the three senior analysts on the investment committee, plus eight analysts. Two new analysts joined in January 2017. The team also benefits from the research of the teams led by Alexander and Harris. The team follows a generalist model.

Parent Pillar: Positive | Kevin McDevitt, CFA 11/05/2015 Two of this fund's board members, Vinod Ahooja and Sharon Osberg, resigned on Oct. 25, 2015, in apparent protest over its concentrated position in recently embattled Valeant Pharmaceuticals. Ahooja and Osberg deserve credit for challenging management over the potential risks of the Valeant position, which claimed 29% of the June 2015 portfolio. Yet, reasonable people can disagree, and management's decision to hold such a concentrated position is not by itself evidence of poor stewardship. That's especially true here because the fund has long held similarly concentrated positions.

The bigger stewardship issue will be the quality of Ahooja and Osberg's replacements. The firm has said that it plans to find replacements before year-end. Based on the quality of current--including respected independent chairman Roger Lowenstein--and past board members, there's good reason to believe that the firm will find replacements of comparable quality.

Overall, the firm still deserves its reputation for strong stewardship. The fund's legendary advisor (Ruane, Cunniff & Goldfarb) is squarely focused on asset management rather than marketing. Sequoia is the family's only fund, although it does have similarly managed separate accounts and hedge funds. Further, the firm limited inflows for 25 years by keeping the fund closed years before reopening in 2008. It closed to new investors again in December 2013.

Price Pillar: Negative | Kevin McDevitt, CFA 02/10/2017 This fund's 2016 1.00% expense ratio was 10 basis points greater than its group median for no-load large-cap funds. However, the April 2016 prospectus shows an expense ratio of 1.03% and puts the fund in above-average fee territory. This leads to a Price Pillar cut to Negative.

This bump in expense ratio may owe to the heavy outflows the fund has suffered in recent years. Since May 2014, the fund has had an estimated $3.2 billion in outflows through December 2016. Assets peaked at $9.3 billion in July 2015. A year and a half later, assets have dropped by $5.2 billion and are at the lowest level since September 2011.