WP: Ruanne Cunniff: An epic winning streak on Wall Street — then one ugly loss

[dr.malone]

The financial whizzes cocooned in the serene offices of the Sequoia Fund atop one of New York’s iconic office buildings seem far removed from the noise of the city far below.

 

But the 47-year-old mutual fund known as much for its ties to billionaire Warren Buffett as for its uncanny stock picks that created massive wealth for clients — retirement funds, pension funds, university endowments and regular-Joe investors — has had to descend from its lofty perch in the past two years and rescue its good name.

 

A big miscalculation on one stock, Valeant Pharmaceuticals International, has cost the Sequoia Fund billions of dollars and compromised its reputation for market-beating performance earned over decades.

 

The rebuilding process comes at a time when investors are leaving stock-picking funds such as Sequoia for index-based mutual funds, which track a fixed basket of stocks. Value stocks such as the ones Sequoia seeks out are finding themselves less loved by a bull market that is on the hunt for the next Apple or Facebook.

 

Sequoia grew to maturity under the glow of Buffett, the folk-hero money mind whose stewardship of Berkshire Hathaway prompted a national following based on the virtues of common-sense investing and avoiding mistakes.

 

The Sequoia Fund has long stood near the top of the Wall Street pyramid. It enjoyed a reputation for sobriety, transparency and a resistance to volatility, which drew blue-chip clients such as The Washington Post. The newspaper for years has listed the Sequoia Fund among its 401(k) options. (This reporter has been a modest Sequoia investor for 20 years.)

 

The Valeant stumble has reverberated.

 

“It was quite painful, but most clients made money on Valeant,” said chief executive David Poppe, sitting in a conference room overlooking the regal Plaza Hotel, with leafy Central Park and the Bronx in the distance.

 

[Your mutual fund manager just doesn’t matter much anymore]

 

Sequoia bet — and bet big — on Valeant. It stuck with the shares even as Valeant was battered by Wall Street and by relentless media coverage of its strategy of using debt to buy drug companies, then laying off employees, doing away with research and jacking up prices — which resulted in embarrassing congressional hearings and federal investigations.

 

Sequoia’s returns eventually tumbled. Its assets under management have been halved from $8 billion pre-scandal to $4.2 billion, with a big chunk attributable to a nose-dive in Valeant stock. It fell from $257 two years ago to less than $15 now, a loss of more than 90 percent.

 

Looking up from the wreckage, Berkshire Hathaway Vice Chairman Charlie Munger called Valeant “a sewer” and its business practices “deeply immoral.” Buffett called it a “Wall Street scheme” with an “enormously flawed” business model.

 

The Sequoia Fund’s Morningstar rating, a respected metric in the mutual-fund industry, dropped from gold to bronze. Longtime fund co-manager Bob Goldfarb, known for contrarian views that unearthed stock gems, retired. Through a spokesman, Goldfarb declined to comment for this article.

 

Sequoia once enjoyed such prestige that it closed itself to new investors. Now, after the loss of some major investors because of Valeant, Sequoia has installed a more rigorous approach to picking stocks and selling them. The company’s annual Investor Day meetings are now more tension-filled affairs with pointed questions.

 

 

“It’s fun to play on a winning team,” Poppe said. “Suddenly we look like a losing team.”

 

 

By the mid-1970s, Ruane, Cunniff found its footing by discovering unnoticed public companies, including The Washington Post Co. Here, Katharine Graham, the Post Co. board chair, is joined by Thornton F. Bradshaw, left, former chair of RCA, and Warren Buffett, chair of Berkshire Hathaway, in 1987. (Mario Cabrera/AP)

Value investing

To understand how and why Sequoia bet the farm on Valeant, you need to understand value investing.

 

The concept is simple: Find the few underappreciated companies that everyone else has ignored. When you find one that is undervalued, buy it. Buy lots of it.

 

Sequoia director John B. Harris put it this way: “The crux of value investing is this notion that the vast majority of people, the investing public at large, tends to get things mostly right but not always right. And sometimes very wrong.”

 

“If you do very diligent research and make analyzing businesses your life’s work rather than just a hobby,” he said, “every so often, you will be able to come to a pretty firm conviction about what the future holds for an individual business. Every once in a while, you will be able to pay a price that’s far below what it’s truly worth.”

 

Go back to 1969. That’s the year William J. Ruane and Rick Cunniff, friends and graduates of the Harvard Business School, founded a stock-picking firm that became known as Ruane, Cunniff & Goldfarb. A year later, the founding partners created their flagship mutual fund, Sequoia.

 

 

Ruane, Cunniff has always had two parts: the Sequoia Fund and, separately, individual clients that include families, individuals, pensions, foundations and endowments. The portfolios of the Sequoia Fund and the private clients are virtually the same.

 

“We think of it as one business, one client, one portfolio,” Poppe said.

 

Ruane and Buffett’s lifelong friendship began at an investment seminar led by longtime Buffett mentor Benjamin Graham, a professor at Columbia University who was called “the father of value investing.”

 

Buffett, Ruane, Cunniff and a cadre of other Graham disciples ran with the value investing ethos, building names and fortunes for themselves. Buffett and Munger are billionaires.

 

The first years were difficult, but by the mid-1970s, Ruane, Cunniff found its footing by discovering unnoticed public companies, including The Washington Post Co. (which had then recently gone public), Interpublic Group and Ogilvy & Mather. In the 1980s, the firm had holdings in Kraft, Sara Lee and Capital Cities. The 1990s produced stakes in Fifth Third Bank, Progressive Insurance, Harley-Davidson and Johnson & Johnson, all of which were sold at healthy profits.

 

Buffett had such faith in Ruane that he would recommend the firm to others. As recently as 2016, Buffett said at Berkshire Hathaway’s annual meeting that he considered himself the Sequoia Fund’s “father.”

 

“I’m the father of Sequoia Fund in that when I was closing up my [buffett] partnership at the end of 1969, I was giving back a lot of money to partners,” Buffett said. “These people trusted me, and they wanted to know what they should do with their money.”

 

“Bill, who would not otherwise have done so, said, ‘I’ll set up a fund,’ ” Buffett recalled.

 

Ruane, Cunniff returned the love. By the early 1990s, Buffett’s Berkshire Hathaway became one of the Sequoia Fund’s core holdings. It has stayed that way since, with its share price rising from $70 to more than $200,000. Berkshire Hathaway constitutes 11 percent of Sequoia’s assets.

 

“Bill ran Sequoia until roughly 2005 when he died,” Buffett said in 2016. “He did a fantastic job, and even now, if you take the record from the inception to now with the troubles they’ve had recently, I don’t know a mutual fund in the United States with a better record. You won’t find many records that go for 30 or 40 years that are better than the S&P.”

 

Part of the key at Ruane, Cunniff was to concentrate on a few stocks, at first maybe eight or 10.

 

Even today, the firm’s portfolio is concentrated, though now the number is closer to 25. That’s very few investments for an $11 billion-plus portfolio. Sequoia’s investments include very un-value-like names such as Amazon.com and Google parent Alphabet. Both are widely owned stocks that are heavily scrutinized. (Amazon chief Jeffrey P. Bezos owns The Post.) Value investors such as Sequoia generally seek ignored, under-the-radar companies that have been misjudged and have room to grow.

 

“Bill had a saying, ‘Your six best ideas in life will do better than all your other ones,’ ” Poppe said. “That ethos has been consistent for the whole 47 years of the firm.”

 

Harris said that “a typical analyst can do six to eight really good projects a year at the most.” Sequoia’s 20 analysts therefore yield about 120 or so proposals a year for consideration.

 

And it has worked. If you invested $10,000 in the Sequoia Fund in July 1970 and never touched it, you would have had $3,961,656 on June 30, 2017. The fund is up an additional 8 percent so far this year.

 

“If your happiness is defined by ‘How many ideas do I get into the fund every year?’ then you’re going to be frustrated,” Harris said. “You can go a year or two or three without putting anything in the portfolio. If you can contribute one really great idea, a big idea every five years that we can scale up and that really works, you are doing a heck of a job.”

 

The company tries to discourage pride of ownership so an analyst doesn’t become hellbent on getting an idea through the five-person investment committee. Still, alphas from Yale or Harvard aren’t likely to be happy beavering away on projects that never reach fruition.

 

It’s not unheard of for a Sequoia analyst to spend a decade investigating a company, going to annual meetings, talking to dozens of employees, managers, customers, suppliers.

 

“We followed CarMax for a decade before we ever bought the stock,” Poppe said.

 

Harris visited 100 stores before the company made a bet on O’Reilly Auto Parts, which has been a huge home run. Sequoia bought the position in the summer of 2004 at a basis of $19.84. Today, it’s worth around $200.

 

“We ignore whatever the daily news is, whether it’s the latest twist in the health-care legislation or the latest blip from the Federal Reserve,” said Roger Lowenstein, one of Sequoia’s outside directors and the author of a book on Buffett. “They just think about what business they want to be part owners of going into the future.”

 

At first, Valeant appeared to be another success story.

 

As Poppe put it: “Valeant and the chief executive [Michael Pearson] had a good insight, which is that the U.S. pharmaceutical industry was spending a lot of money on [research and development] and not getting a great return on original research and development ideas.”

 

“What if you could build a pharmaceutical company using low interest rates and cheap cost of capital to acquire products in some area where the doctors . . . have a lot of authority over prescribing?” Poppe said. “That strategy made sense to us. And it worked for a pretty good period of time.”

 

But what Sequoia married itself to was an offshore drug company that borrowed heavily to buy other drug companies, cut costs and research, then raised prices on many older drugs to astronomical heights. It quadrupled the price of a 55-year-old drug that treats a rare genetic disorder. The Valeant playbook repeated this high-risk, debt-laden tactic through 30 acquisitions in five years.

 

“Goldfarb became very enthralled with the Valeant chief executive,” Morningstar analyst Kevin McDevitt said. “He looked at Pearson as a once-in-a-generation capital allocator. That’s kind of what Sequoia did with Berkshire Hathaway. Berkshire was the rock of this portfolio. They tied themselves to one stock and made it their centerpiece.”

 

Around 2010, Ruane, Cunniff began buying 34 million shares at around $19, which came to about a $650 million investment. By 2015, that stake had risen above $8.5 billion, riding the arc of Valeant’s stock price to $260 per share.

 

[Meet the woman who gives bridge tips to Warren Buffett and Bill Gates]

 

Then-Sequoia director Sharon Osberg worried that Valeant was too big a piece of the portfolio. “Sequoia continued to buy when I felt it was an extremely risky investment and way too large a percentage of our portfolio,” Osberg said. “It was a huge threat to the fund.”

 

By fall 2015, Valeant showed signs of souring.

 

“The Valeant management team made an acquisition in 2015 at a very high price,” Poppe said. “They paid for the whole thing in debt, so that added a lot of risk to the business.”

 

But Sequoia failed to adjust.

 

Goldfarb in October 2015 decided to buy more shares, even as the stock was dropping by half to around $120 a share. The drop came as Valeant cut its ties with a controversial mail-order pharmacy called Philidor after it was accused of being a “phantom pharmacy” used to artificially boost sales.

 

Osberg had seen enough.

 

“It was during a board phone call when we were discussing this, and somebody, it might have been me, said, ‘You are not buying more Valeant, are you?’ ” Osberg recalled. “And Bob [Goldfarb] had just made another large purchase by the Sequoia Fund. I resigned the next day.”

 

In 2016, Sequoia finally sold its shares in Valeant in the high $20s, or for about $1 billion.

 

Lowenstein said he was not concerned with the initial stakes that Sequoia bought.

 

“We have had various positions in the high single and even in the low double digits” as a share of the portfolio, Lowenstein said. “When, through appreciation, it grew and became a much bigger part of the portfolio, each of the outside directors expressed concerns.”

 

At the end of the day, in the world of investing where stock-pickers are judged by knowing when to take some chips off the table, Sequoia had waited too long. Its performance took big hits for three years in a row — in 2016 by a whopping 18.86 percentage points.

 

Some investors are still angry.

 

“They made a huge mistake,” said Steve Goldberg, who runs Tweddell Goldberg, an investment management firm in Silver Spring, Md. Goldberg said he made money with Sequoia but got out when Valeant started plummeting. “This was literally a drug company that was doing no [research and development]. They just bought the drug and raised the price on it. A hell of a business model. Why did they buy a company that wasn’t doing anything but [acquisitions]?”

 

Valeant’s denouement included a tense Senate hearing; the departure of Pearson, once the highest-paid chief executive in Canada, at $182.9 million; criminal charges involving fraud; and kickbacks involving the mail-order pharmacy. Activist investor Bill Ackman, long a defender of the company, eventually surrendered his Valeant shares at a $4 billion loss.

 

How, with all its deep research and money minds, did Sequoia get this so wrong?

 

The decision to invest and stick with Valeant “was not about one person,” Poppe said.

 

There is no good answer.

 

“It almost begins to feel like a Greek tragedy,” McDevitt said. “Goldfarb had been revered in the industry, and rightfully so. For years, he would get it right, even when people said it was wrong. If you are successful when the market says you are wrong, it can create a sense of hubris. It can leave you overconfident in your own opinions and can set you up for a big fall. And that is what happened.”

 

 

Ruane, Cunniff & Goldfarb, with offices in the famed Solow Building, pulls in more than $100 million a year in revenue from its 1 percent annual fee on the combined $11 billion that the firm manages. (Astrid Riecken for The Washington Post)

High expectations

It is free-lunch Friday at Sequoia, and this reporter is stunned at the view as I enter the 50th-floor offices where the Sequoia Fund is headquartered. The company is ensconced on the top floor of 9 W. 57th St., New York.

 

The Solow Building, informally named for its owner, speaks money. Current and former tenants include the French fashion and fragrance company Chanel and private equity firms Kohlberg Kravis Roberts and Apollo Global Management.

 

I once asked a prominent real estate mogul in New York, “What is the most prestigious and valuable piece of New York commercial real estate?”

 

Nine West 57th, he said without a moment’s pause.

 

Its architect was one of the most prominent of the mid-20th century, Gordon Bunshaft of Skidmore, Owings and Merrill. Owner Sheldon Solow, a college dropout and son of a bricklayer, rode this marble-and-glass landmark to a $4 billion fortune.

 

Ruane, Cunniff can afford the offices. Its 1 percent annual fee on the combined $11 billion that the firm manages creates more than $100 million a year in revenue.

 

[The story behind Atlantic owner David Bradley’s ‘biggest business failure’]

 

Over the years, the firm developed an almost cultlike, word-of-mouth following. It stopped taking on new clients for many years so its assets did not become unwieldy, which would make it difficult to find companies that could positively affect results. Fewer clients also meant fewer assets under management. And fewer assets meant the 1 percent fee was collecting from a smaller pot, which in turn meant less income for the owners.

 

The founders didn’t care. “Bill and Rick had a strong conviction that they wanted to die having beaten the S&P 500 more than they wanted to die having maximized our assets under management,” Poppe said.

 

The $100 million covers salaries for its 60 employees, including Wall Street salaries for its 20 analysts who travel widely researching companies. There are legal expenses, trading and regulatory expenses, fees and expenses for the fund’s directors. If there are profits after expenses, they are paid in distributions to the Ruane, Cunniff private owners, comprising employees and outside shareholders, including the Cunniff family. There are more than a dozen shareholders in all.

 

The firm nurtures a filial atmosphere with an almost solemn devotion to the legacy of the founders and their value-based belief system. One keeper of the flame is Jonathan Brandt, the resident Berkshire Hathaway analyst and 25-year employee whose father worked at Ruane, Cunniff. His father was an intimate of Buffett’s.

 

Everyone seems to have tenure. “I can only think of two people who have left over my 25 years here,” Brandt said. “They generally don’t leave.”

 

Poppe, a former journalist with the Miami Herald, has been at the firm 18 years. Harris, 15. Former Wall Street Journal reporter Greg Steinmetz, 17.

 

In the wake of the Valeant affair, the firm has overhauled its stock-picking process. Under the old system, Goldfarb, Poppe and one other rotating analyst decided when to make an investment and whether to end one. That has changed to a five-person investment committee requiring four votes to make a move.

 

“Four-to-one strikes us as a high hurdle,” Poppe said. “Something has got to be really good, and there’s got to be great conviction before we want to make that investment.”

 

Were they ever worried the firm was not going to survive Valeant?

 

Poppe paused a second. “I worry about everything,” he said, “but I didn’t actually worry that the firm was not going to make it.”

 

Harris added, “Not for a second.”

 

Several members of the senior team have doubled down on Sequoia by purchasing its shares. Most of them have virtually their entire net worth tied up in the firm, through direct ownership of shares in Ruane, Cunniff or through ownership of Sequoia Fund shares.

 

Sequoia is prospering, with year-to-date returns just shy of 10 percent. Morningstar’s McDevitt said it could use a home run.

 

“This is a time where from an optics standpoint,” he said, “they want to be performing really well.”

 

Poppe and his senior team said performance will go a long way to washing away the Valeant stain.

 

“We have to do a great job for our clients,” Harris said. “Pretty much everybody at this firm came here because they thought it was . . . one of the few beautiful cathedrals to value investing. And they wanted to live and work inside it.

 

“If it’s got a little bit of dirt on it now, then we need to wipe it off and get back to doing what we’ve always done.”

[Viking]

Dr. Malone; thanks for posting. I really like the following quote "your 6 best investment ideas in life will do better than all the other ones".

 

It speaks to the fact that in a lifetime most investors will get only a handful of crazy good (life changing) investment opportunities. The key is to take advantage of them when they come (through concentration). At the same time you also need to make sure that you are not wrong (and that said concentration does not blow up your portfolio). Very simple. Very difficult to execute over time.