When to Head for the Exits

Back in November, I wrote about the Sequoia fund (ticker symbol: SEQUX) on the losing side of a big bet on Valeant Pharmaceuticals (ticker symbol: VRX).

Sequoia is a well-known fund, in part because when Warren Buffet unwound his hedge fund in the late 1960s, he recommended that his clients go to Sequoia, which was run by his friend Bill Ruane.  Sequoia had good results and wasn’t afraid to take big bets on stocks that they liked: the fund had a third of its assets in Buffets Berkshire Hathaway for extended periods.

The bet on Buffet paid off, but their equally sized position in VRX turned out to be a dud.  At the time of my last article, VRX had lost 70 percent of its value, falling from $260 per share to $85 per share.  The same day that I published my article, the New York Times reported that two of the independent directors at Sequoia quit over the VRX bet.

Things haven’t gotten better for VRX – the stock closed yesterday at $27, a decline of nearly 70 percent since my article and 90 percent from the $260 price in August.  The stock is now specifically mentioned by Presidential candidates and some investors are wondering whether it’s another Enron in terms of its accounting (thankfully, not in terms of its market impact).

That hasn’t been good for Sequoia either, which is down more than -10 percent this year while the market is up slightly (both were down quite a bit more earlier this year).  The fund manager of 35 years stepped down and Morningstar lowered their forward looking rating from Gold to Bronze.

The VRX position is down to around 20 percent, according to its December 31st filing, but it’s hard to know whether that’s because they’ve been cutting the position or VRX just shrinking that fast compared to their other holdings (often referred to as cutting your position the hard way).

For us, this kind of concentration is a real no-no, for exactly this reason.  I have no doubt that the folks at Sequoia are very smart and did extensive research while building their position, but got burned anyway.

I like to think that even if we had held the stock (at a much smaller weight), we would have sold it in November simply because VRX was accused of possibly fraudulent accounting.  Without accurate financial statements, there is no way to understand the value of a company and if you can’t trust management to produce fair statements, you can’t trust anything.

We learned this lesson with Enron way back in the day.  We were burned on it badly, but we sold well before it hit zero because we bailed out when the accounting accusations got too loud.  Even though we were burned on the stock, though, it probably didn’t account for more than one percent of any single client account, so the damage wasn’t too bad.

I would say that, in general, our exposure to any single stock has decreased since our early days.  We’re much more focused on the big, systematic sources of return like value, momentum, size and quality.  They have their risks of course, but nothing like a concentrated bet on a single company with accounting problems.