A fund that once boasted one of the best long-term track records and a friendly relationship with Warren Buffett (Trades, Portfolio) found itself maimed by a series of negative developments at its top holding, Valeant Pharmaceuticals (VRX) in recent months. The stock's months-long plunge and Sequoia's large exposure prompted mutual funds rating company Morningstar to place its analyst rating under review Wednesday. It also caused Sequoia's manager to say their "credibility as investors has been damaged by this saga," but few saw the sinkhole coming.
The intrinsic value of VRX
One of Morningstar's primary arguments for the review of Sequoia was its portfolio's sizable concentration in Valeant, charging managers with taking no steps to "mitigate the risks of such a large position." Yet Sequoia had skirted traditional mutual fund diversification in the past to good result. Buffett's company, Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B), ballooned to 35% of the fund in the 1990s, the New York Times reported, its only position to exceed Valeant in size.
Berkshire, though an inarguably safer bet than the fickle pharmaceuticals industry, spent the '90s climbing 690%. The investment heaped returns on Ruane Cunniff; it beat the market in seven out of 10 years of the decade.
The firm started buying Valeant in 2010, after taking a 27% loss in 2008 and falling more than 10 percentage points short of the market in 2009. During Valeant's furious subsequent ascent, Sequoia beat the S&P 500 index only three out of six times, but it still did well enough to continue compounding its clients' money at a brisk pace. In its 45-year existence, it has had an annual average return of 14.01%, compared to 10.75% for the index.
With Valeant, it appeared that Sequoia might parallel its Berkshire days, and the holding crept from 17.4% of Ruane Cunniff's total portfolio at the start of 2011 to its maximum of 35.1% by mid-2015. Valeant was the single position that contributed most to the fund's lofty returns in recent years. At a shareholder meeting in the first quarter 2015, managers responding to one person's question by explaining that sans Valeant, it would have returned less than 1% instead of 12%. In 2013, Valeant's 100% rise contributed 12% to its 35% return, while other stocks generated 23 points of return.
Then, as early as May 2015, the position's size was drawing many questions from shareholders and analysts at its investor day. When asked whether he planned to maintain its percentage of the portfolio, manager Bob Goldfarb indicated no plans to sell.
"We believe that the company will continue to grow EPS at a rapid rate and that the stock should do quite well," he said.
Like most value investors, the managers also said that minor negative events would not change their mind.
"So it depends on what the negative development is. Some things are temporary and fixable, and some things may seem more intractable. We would not be sellers because there is negative news like a short term earnings miss or something like that," Sequoia Manager David Poppe said.
Some guests also took issue with the company's dubious practice of buying other companies' drugs and raising the prices by hundreds-fold while spending relatively little on its own research and development. For Sequoia at the time, the mechanisms of capitalism excused high drug prices and it boiled its decision more down to price of the stock.
"I understand why reaction to that could be negative. Obviously, Sequoia and our clients that own Valeant are benefiting from those price increases. But in general, the capitalistic approach to pricing is to charge what the market will bear," Ruane Cunniff analyst Rory Priday said.
"Valeant believes that when it buys a drug and it is underpriced, it should charge a price that will maximize the company's long- term cash earnings. Some people maybe feel differently about healthcare. It is obviously a more sensitive topic."
On the surface, the profits generated from its business model appeared to produce stellar results. Valeant racked up a 40.9% average annual revenue growth rate and a 55.9% rate for EBITDA over the past five years. It also gushed free cash flow for a straight decade. Its financials did show at least one glaring flaw -- as of Sept. 31, it had $1.4 billion in cash and $30.2 billion in debt.
It would have been difficult for Ruane Cunniff (Trades, Portfolio) to foresee Valeant's most recent bombshells - a short-seller questioning its relationship with pharmacy Philidor (from which it severed ties immediately) and accounting discrepancies. Its two board members to resign did so after this information came to light and the company continued to buy more shares on the price drop in the fourth quarter.
From Morningstar's view, however, in retrospect these initial problems have "morphed into more fundamental questions about its business model, pricing practices, management, transparency, and debt load, as well as an SEC investigation," Morningstar senior analyst Kevin McDevitt said.
Wallace Weitz (Trades, Portfolio), chief investment officer and portfolio manager of Weitz Investment Management, also retained his Valeant position at least through the scrutiny that swirled around its pricing practices by politicians in September.
Ultimately, it was "difficult-to-answer questions, Valeant's potential long-term reputational impact, future business model uncertainty and financial leverage" that led Weitz to exit his position in October.
Weitz later told WealthTrack with Consuelo Mack in February that at a dinner with Valeant CEO Mike Pearson said he told employees, "Make your numbers, or we'll get somebody who will," which put Weitz on guard early.
"I think an awful lot of the corporate blow-ups over the years, whether it's Enron or whatever, maybe start off as legitimate companies that are well-run," he said, "but when there's pressure from the top to make the numbers, sometimes people succumb to that and bad things happen."
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This article first appeared on GuruFocus.
The intrinsic value of VRX