Please ensure Javascript is enabled for purposes of website accessibility

Did One Decision Destroy Sequoia?

By Bill Mann - May 4, 2016 at 5:05PM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

Bill Mann looks at the lessons investors can learn from the troubles of the Sequoia Fund.

If you follow the markets at all, you've probably heard a thing or two about some hedge funds and mutual funds that have been clobbered by their holdings in Valeant Pharmaceuticals (BHC 20.36%), which is down nearly 90% from its peak share price last July.

Bill Ackman at Pershing Square has been the subject of a lot of media attention, perhaps because of his utterly perfect hair and his tendency to hold press conferences nearly indistinguishable in length from hostage situations. But perhaps the saddest, most shocking loser in the collapse of Valeant is the venerable Sequoia Fund (SEQUX), managed by the legendary value-investing shop of Ruane, Cunniff, & Goldfarb.

Actually, "legendary" doesn't begin to describe Sequoia. Bill Ruane was a good friend of Warren Buffett's, and when Buffett elected to shut down his partnership back in the 1960s, he recommended that investors place their money in Sequoia.

That was then. Today, Ruane, Cunniff's sole remaining named partner, Robert Goldfarb, has resigned in disgrace after 45 distinguished years at the firm, and the company's reputation may be damaged beyond repair. The Sequoia Fund has seen more than half a billion dollars in redemptions, and as a result it has been forced to redeem shareholders "in kind," transferring stock held in the portfolio to them rather than taking the tax hit themselves to sell shares to create sufficient cash. It's totally legal, but it's a mark of total desperation -- a death throe, perhaps.

Sequoia Fund had come to own more than 10% of Valeant Pharmaceuticals, at one point allocating more than 30% of the fund's money to this single name. Non-diversified mutual funds are welcome to hold large stakes in companies they hold in high regard. But a 30% position in any one name is, almost by definition, contrarian. To be a contrarian investor, one must be confident. And to be a successful contrarian investor, one must also be humble.

Our friend Chuck Jaffe wrote a terrific article at the end of last month titled "How a Big Bet on One Bad Stock Broke a Legendary Mutual Fund," which gives a perfect synopsis of what took place at Sequoia. He even reminds us of the Sequoia-Steadman standard, which analysts used to place other funds on a continuum, somewhere between Sequoia (the best) and Steadman Funds (the worst). Jaffe's take is perfect in every way, except for the conclusion: What happened at Sequoia isn't a story of a legendary firm making a bad bet. Rather, it's the story of a group whose research process had become arrogant.

I don't have any visibility into the offices of Ruane, Cunniff, & Goldfarb, of course. But given the internal strife, the directors who resigned in protest over the massive stake in Valeant, the rumors of "expressed concern," and Goldfarb's dismissal of those concerns, there is a rather troubling narrative here -- one of a research process that was rendered impotent by powerful members of the team who crushed dissent, of managers whose cherished independence became imperiousness and a reluctance to consider alternative views.

While Valeant wasn't a household name until Martin Shkreli tap-danced before Congress and brought attention to rent-seeking pharmaceutical companies, many investment analysts had pointed to weaknesses in Valeant's business model and accounting for years.

No, the fund's massive bad bet on Valeant was not the cause of the fund's collapse, but merely a symptom of a dysfunctional culture. If Valeant had never collapsed, then Ruane, Cunniff, & Goldfarb would still be sick to the core.

One of my favorite investors, Seth Klarman, points out that the only thing investors can really control in their world is their decision-making process. Results are at least partially an outcome of that process, but they also involve a lot of other factors, including -- it must be said -- plain dumb luck. After years of spectacular investment returns and the reflected glory of Warren Buffett's long-ago recommendation, Sequoia ended up with a process that had grown flabby and corruptible.

It's always important that investors check their egos at the door. David Snowball of the excellent Mutual Fund Observer quipped that at Sequoia, "independence stops at the boss's door," and he might have been right about that. When reviewing any company, it's important for investors to remember that the true challenge is determining how good of an idea it is as a potential investment.

In the end, the fact that a single stock took down a fund at Ruane, Cunniff, & Goldfarb speaks to the need for higher diversification requirements. Still, turning a collaborative process into an echo chamber through years of tiny shortcuts is always a risk -- one that investors should avoid at all cost.

But be alert
No matter where or how you invest, it's always important to control your costs. That's why my team produced a special report uncovering a number of "hidden costs" you might not normally consider. It's absolutely free, and you can access it by following the link here.

Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Stocks Mentioned

Bausch Health Companies Inc. Stock Quote
Bausch Health Companies Inc.
BHC
$8.75 (20.36%) $1.48
Sequoia Fund, Inc. Stock Quote
Sequoia Fund, Inc.
SEQUX

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning analyst team.

Stock Advisor Returns
321%
 
S&P 500 Returns
111%

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 06/25/2022.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.