The Sequoia Fund is a mutual fund founded by William Ruane in 1970. Both Ruane and Warren Buffett took a class from Benjamin Graham, the father of value investing, in 1951. When Buffett wound down his original partnership he recommended Ruane’s newly formed Sequoia Fund exclusively to all of his partners. The fund has performed extremely well over the years, and currently has a 5-star rating from Morningstar. In Buffett’s famous essay The Super Investors of Graham-And-Doddsville regarding the success of value investing, the Sequoia fund is listed as one of the prime examples. $10,000 invested in 1970 would be worth $2.89 million at the end of 2012, an annualized gain of 14.8%.
A good investor should always be on the lookout for new ideas. A great place to look for those ideas is the portfolio of a fund such as Sequoia. Sequoia had 44 positions at the end of 2012, but the ten largest positions represented 65% of common stock investments. Let’s take a look at the three largest holdings.
Valeant Pharmaceuticals Intl Inc (NYSE:VRX)
Valeant Pharmaceuticals Intl Inc (NYSE:VRX) makes up 11.6% of Sequoia’s holdings and had returned 28% for the fund by the end of 2012. The stock price has actually risen another 17% in 2013, meaning that the total return is now significantly higher. Valeant Pharmaceuticals Intl Inc (NYSE:VRX) is a small pharmaceutical company, with $3.5 billion of revenue in 2012. Over the past 5 years revenue has grown at an annualized rate of 47% as the company has grown both organically and through acquisitions. In 2011 Valeant Pharmaceuticals Intl Inc (NYSE:VRX) spent a staggering $2.4 billion on acquisitions, followed by $3.4 billion in 2012. Quite a bit of debt was taken out to fund all of this, as the company went from no debt in 2008 to about $11 billion in debt at the end of 2012.
In Sequoia’s annual report the fund expects these acquisitions to provide substantial earnings accretion. Written before Valeant Pharmaceuticals Intl Inc (NYSE:VRX) reported full-year figures, the fund expected cash earnings to be about $4 per share in 2012, and significantly more in 2013. While EPS came in at $-0.38 for the year, this is not what they mean by cash earnings. They most likely are referring to owner earnings, a phrase coined by Warren Buffett.
Looking at the cash flow statement owner earnings, including tax-adjusted interest payments, comes out to $4.44 per share, assuming a tax rate of 35%. The firm has about $33 of debt per share, so with a market price of about $70 this puts the market cap plus debt at roughly $103 per share, or 23 times owner earnings. In 2011 my calculation of owner earnings is $2.66 per share, so 2012 saw 67% growth. I would expect 2013 to see significant growth as well, given the huge acquisitions, but long term the growth rate should slow. A price of 23 times owner earnings doesn’t seem unreasonable given these growth prospects.
What I don’t like about Valeant Pharmaceuticals Intl Inc (NYSE:VRX) is the massive debt they’ve taken on to fund these acquisitions. About 13% of the company’s revenue went to interest payments in 2012, which is higher than I’d like to see.
Berkshire Hathaway Inc. (NYSE:BRK-B)
It’s somewhat fitting that Sequoia has 10.9% of its assets investing in Warren Buffett’s Berkshire Hathaway Inc. (NYSE:BRK-B). Berkshire is a difficult company to even attempt to value, complicated by its vast insurance holdings, manufacturing companies, and enormous investment portfolio. Buffett uses the growth of the book value to roughly gauge performance, and in 2012 per-share book value rose 14.4%, lower than the annualized gain of 19.7% since 1965.
Buffett has been extremely reluctant to buy back shares, but in 2012 spent about $1.3 billion on share buybacks. He has stated that he views the book value an a significantly understated proxy for intrinsic value, and that below a P/B ratio of 1.2 he’s willing to buy back shares. This puts a floor on the value of the stock to some degree. Currently Berkshire trades at about 1.3 times book value.
As Berkshire Hathaway Inc. (NYSE:BRK-B) has grown larger it has become more difficult to achieve the high returns of the past. Now a company valued at $252 billion, acquisitions that are capable of making a real impact on the business are few and far between. Buffett has said that he’s actively looking for so-called elephants, and the $23 billion buyout of H.J. Heinz Company (NYSE:HNZ) earlier this year is an example. It’s hard to say if Berkshire Hathaway Inc. (NYSE:BRK-B) can continue to grow at historical rates, and Buffett’s age is another looming issue. Can Berkshire Hathaway Inc. (NYSE:BRK-B) continue to be successful without Buffett, or will the company stagnate after he’s gone? Only time will tell, I suppose.
The TJX Companies, Inc. (NYSE:TJX)
TJX is a leader in off-price retailing, with revenue three times that of its closest competitor. TJX makes up 7.5% of Sequoia’s assets and returned 33% for the fund in 2012. The company saw 11.5% revenue growth and 32% EPS growth in 2012, and the company spends part of its robust cash flow on significant share buybacks each year. The balance sheet looks strong, with more cash than debt, and the company looks poised to continue to see strong earnings growth in the future.
The company is currently trading at about 17.6 times earnings, which given the strong earnings growth looks like a good deal. Sequoia expects that the company can increase its store base by 5% per year, and along with repurchasing 4%-6% of its shares each year even flat same-store sales growth could lead to double-digit rates. This leads me to believe that the average analyst estimate of 11.6% for 5-year earnings growth is on the low side, representing a sort of worst-case-scenario.
The company’s return on equity was 52% in 2012 and it’s return on assets was an impressive 20%. Coupled with a strong free cash flow of $2 billion last year, this company has a bright future ahead of it.
The bottom line
The Sequoia Fund has a long history of success using its value-driven approach, and its top holdings look like excellent investments. Looking through the holdings of top funds like Sequoia is a great way to find ideas that warrant further study. I like TJX, a company that I hadn’t heard of before looking at Sequoia’s portfolio, which goes to show you that there is plenty to be learned from this type of exploration.
Data from Morningstar
The article The Top Holdings of This Legendary Value Fund originally appeared on Fool.com.
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