Big Mistakes

by Michael Batnick

  Druckenmiller got on that trolley. He couldn't bear to see Quantum grinding its gears as a bunch of small‐potato upstarts were racking up huge returns. Firms that were heavily into tech stocks were up as much as 50% for the year, while Quantum was stuck in single digits.

  Druckenmiller knew exactly what he was doing – he just couldn't stop himself. “I bought $6 billion worth of tech stocks, and in six weeks I had lost $3 billion in that one play. You asked me what I learned. I didn't learn anything. I already knew that I wasn't supposed to do that. I was just an emotional basketcase and couldn't help myself. So maybe I learned not to do it again, but I already knew that.”25

  Maybe we all need to have this happen once or twice. Some things can't be taught, they have to be learned the hard way, even if we don't learn anything at all.

  Notes

  1. Charles D. Ellis, Winning the Loser's Game, 7th edition (New York: McGraw‐Hill, 2017), 3–4.

  2. Ibid.

  3. Cullen Roche, posted on Twitter, @cullenroche, August 24, 2015.

  4. Quoted in Michael Batnick. “When Something Is Obvious,” The Irrelevant Investor, July 21, 2017.

  5. Introduction to Stanley Druckenmiller's speech at the Lost Tree Club, Palm Beach, Florida, January 18, 2015.

  6. Quoted in Sebastian Mallaby, More Money Than God (New York: Council on Foreign Relations, 2011), 148.

  7. Jack D. Schwager, The New Market Wizards (New York: HarperBusiness, 1994, 197.

  8. Druckenmiller, speech at the Lost Tree Club.

  9. Ibid.

  10. Schwager, New Market Wizards, 193.

  11. Ibid., 230.

  12. Ibid., 218.

  13. Ibid., 237.

  14. Mallaby, More Money Than God, 166.

  15. Ibid.

  16. Ibid., 150.

  17. Ibid., 178.

  18. Ibid., 180.

  19. Edward Wyatt, “Market Place; Soros Advisers to Establish Separate Firm,” New York Times, May 18, 1999.

  20. Mallaby, More Money Than God, 258.

  21. Quoted in Gregory Zuckerman, “How the Soros Funds Lost Game of Chicken against Tech Stocks,” Wall Street Journal, May 22, 2000.

  22. Quoted in Floyd Norris, “Another Technology Victim; Top Soros Fund Manager Says He ‘Overplayed,’” New York Times, April 29, 2000.

  23. Stanley Druckenmiller, introductory remarks, Ira Sohn Conference, New York, May 8, 2017.

  24. Charlie Munger, opening comments, Wesco Annual Meeting, Pasadena, CA, May 7, 2003.

  25. Druckenmiller, speech at the Lost Tree Club.

  CHAPTER 11

  Sequoia

  The Risks of Concentrated Investing

  Your six best ideas in life will do better than all your other ones.

  —Bill Ruane

  “Tis the part of a wise man to keep himself today for tomorrow, and not venture all his eggs in one basket.” This timeless wisdom comes from Miguel de Cervantes's Don Quixote, which was published more than 400 years ago. Spreading your bets around is smart risk management and plain old common sense. A basket of 100 stocks exposes you to less idiosyncratic risk than a basket of just 10 stocks. If you hold 100 stocks, equally weighted, and one goes to zero, all else equal, you will have lost 1%. If you hold 10 stocks, equally weighted, and one goes to zero, all else equal, you will have suffered a 10% decline.

  With a diversified US stock portfolio, one could have historically earned 8% a year. At that rate, it would take nine years to double your money. Certainly not bad, if you're starting with a large capital base, but nobody is going to retire at 40 by earning 8% annually. At that rate, it would take 91 years to turn $1,000 into $1 million. Diversification is one of the most basic principles in finance and lies at the center of modern portfolio theory. But why would you invest the same amount in your 20th best idea as your very best idea?

  There's an old adage in finance, “Concentrate to get rich, diversify to stay rich.” If you find one of the super compounders and hang on tight, you can build enormous fortunes in the stock market. When Warren Buffett first took control of Berkshire Hathaway stock in 1962, its market capitalization was around $22 million.1 Berkshire gained 50% or more in a year 10 times and compounded at nearly 21% for 53 years, resulting in a $450 billion market capitalization today. Buffett did not become one of the richest men in the world by spreading his bets across his top 100 ideas.

  Berkshire is in that rare group of stocks that is responsible for the majority of the market's long‐term gains. The distribution of total stock market returns is heavily skewed toward these giant winners. The top 1,000 stocks alone, or less than 4% of the total public companies since 1926, have accounted for all of the market's gains. Exxon Mobil, Apple, Microsoft, General Electric, and IBM have each generated over half a trillion dollars in shareholder wealth.2 The hunt for these potentially life‐changing stocks motivates millions of market participants each day. But for every Berkshire Hathaway, there is a Sears Holdings, a GoPro for every IBM. While “concentrate to get rich” is certainly true, it's not wise financial advice. The stocks that produce these gigantic returns always appear obvious in hindsight, but in real time, finding and holding them is harder than hitting a 100 mph fastball. Concentrate in any one of the super compounders and you're a legend, but concentrate in a few losers and you're out of business.3 Armed with this information, diversification sounds like a smart alternative.

  Casual investors typically don't hold concentrated portfolios. Not many people working a 9 to 5 job have the time to dedicate to researching and monitoring this type of portfolio. But if you are one of those people, assuming you've done the necessary work that is required to have confidence in holding a big position, there are a plethora of risks to be aware of. First and most obvious, you might just be flat‐out wrong. But this is merely the tip of the potential iceberg when it comes to things that can go wrong.

  If you put in tens or maybe even hundreds of hours into researching a company, the sunk cost is very real, and potentially very expensive. The more time you've spent coming to a conclusion, the harder it is to change your mind. It's one thing for traders to buy and sell stocks at a machine‐gun pace. You buy this stock and it's not working, so get rid of it. But for the fundamental investor, if what you consider to be one of your top ideas isn't working, you're more likely to add to the position than you are to come to the conclusion that you missed something. If you loved the stock at $100, at $90 you're buying more, and at $80 you're thanking the market gods for this opportunity. But what do you do at $70, $60, and $50? This isn't just theoretical, this should be expected. Almost all of the best stocks get killed, however, they don't all come back, and it's only with the benefit of hindsight that we can separate the winners from the losers.

  Investors can learn of the dangers embedded in running a concentrated portfolio by studying one of the most successful mutual funds of all time, one that was able to separate the winners from the losers, went all in on their best ideas, and beat the market for decades – the Sequoia Fund.

  Sequoia is run by Ruane, Cunniff & Goldfarb, which, since 1970, has been utilizing a long‐term strategy based on extensive research honed to outperform the S&P 500 Index. According to The Washington Post, “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.”4 Can you imagine spending a decade researching a company that you don't even own? What if while you're watching it, the stock gains 500%? How do you not kick yourself for buying earlier? And how is it possible to spend 10 years studying the company and then not buy?

  Sequoia is not interested in short‐term profits, or 1% positions. They expect to hold their stocks for a long period of time and to earn a significant return above and beyond an index. To achieve long‐term success with this type of approach requires exhaustive due diligence. One of Sequoia's holdings, O'Reilly Automotive, an auto parts retailer, was one such success story. In 2004, when Sequoia bought, O'Reilly wa
s worth $19.84. By year end 2017, it was worth about $240, despite suffering a nearly 40% drawdown that year. But winning that big takes a lot of planning. Fund director, John B. Harris, did extensive research on O'Reilly, which included visiting 100 stores.5 The fund and its investors aren't shedding any tears over the recent drawdown as it was the rare 10‐bagger that eludes most investors. But Sequoia's intensive research doesn't always result in a happy ending, and the fund was front and center in one of the biggest disasters in the history of concentrated positions.

  The website of Ruane, Cunniff & Goldfarb, Sequoia's firm, describes their strategy like this:

  In managing the Fund, Ruane, Cunniff pursues a value‐oriented approach, seeking to outperform over the long‐term by purchasing shares, at prices below our estimated range of their intrinsic values, in high‐quality businesses that have significant and durable competitive advantages.6

  If that sounds exactly like something Warren Buffett would write, it's not a coincidence, Sequoia's story cannot be written without him. Not only was Berkshire Hathaway its largest holding from 1990 to 2010, but also Buffett is the reason Sequoia exists in the first place.

  In 1969, Warren Buffett decided to close his limited partnership. He had felt, rightly, that the market had gotten so far ahead of itself, in terms of price relative to value, that there weren't enough opportunities to invest with the margin of safety that he sought. But he did not want to leave his investors to navigate the coming turbulent waters on their own, because he knew a shark would come along and drag them under. So he hand‐selected Bill Ruane to be the steward of their capital. As he wrote in his famous essay, “The Superinvestors of Graham‐and‐Doddsville”:

  When I wound up Buffett Partnership I asked Bill if he would set up a fund to handle all of our partners so he set up the Sequoia Fund. He set it up at a terrible time, just when I was quitting. He went right into the two‐tier market and all the difficulties that made for comparative performance for value oriented investors.7

  Not surprisingly to Buffett, stocks did poorly over the next few years and value stocks did even worse. Sequoia got off to a rough start, underperforming the S&P 500 in each of its first three years. Since its inception in the middle of 1970 through the end of 1973, $1 shrank to $0.85. Things were so bad that Bill Ruane and Richard Cunniff almost shut it down in 1974.8 But they didn't, and with the help of Buffett's loyal acolytes, they persevered.

  The early investors that stuck with the fund have been handsomely rewarded. Sequoia has outperformed the S&P 500 by 2.6% a year for 47 years.9 $10,000 invested in July 1970 would have grown to nearly $4 million today. This is three times as much as one could have earned by buying and holding the S&P 500.10

  Every investment strategy that doesn't deviate from its core tenets, whether its value or trend following or anything else, will have long periods of time where it looks and feels foolish. The dot‐com bubble was that period for all value investors, including Ruane & Cunniff. In 1999 the Sequoia Fund lost 16.5% while the S&P 500 gained 21% and the tech‐heavy NASDAQ Composite gained 86%! At the time, Sequoia was running a super concentrated portfolio of just 12 stocks, with 37% invested in Berkshire Hathaway. When the tide turned and value got its vogue back, investors who stayed with Sequoia were vindicated. From 2000 through 2002, the fund gained 29% as the S&P 500 (total return) fell 38%.11 Sequoia has experienced tough times and bounced back, but it remains to be seen whether or not they come back from their most recent saga. It's understandable when value investors don't keep up in a market driven by growth stocks, but Sequoia's recent setback has nothing to do with the current market regime. This wound was self‐inflicted.

  In Sequoia's 2010 annual report, they told investors that they were evolving, that the super‐concentrated portfolios were a thing of the past. “Another gradual change at Sequoia has been an increase in the number of holdings. At the end of 2010, we held 34 stocks in the Fund, which we believe is an all‐time high.”12 But you can't teach an old investor new tricks, and the Sequoia Fund would be back to its concentrated ways in short order.

  It was in that same report, ironically, that they introduced what would become an extraordinarily large position, Valeant Pharmaceuticals. They first began purchasing shares on April 28, 2010, at $16. Valeant gained 70% that year and it quickly became the fund's second largest holding. Through the first three months of 2011, Valeant gained another 76%, and for the first time in 20 years, Berkshire Hathaway was no longer their largest holding. That year, with Valeant's wind at their backs, they outperformed the S&P 500 by double digits for the first time since 2003.13

  The fund was doing great and investor demand was so strong that assets under management had nearly tripled from the time they first bought Valeant. The fund did what few responsible stewards of capital do – they shut it to new investors. (This was not the first time this happened. Sequoia closed to new investors from 1982 until 2008.)14

  They rode Buffett's coattails and they planned to do the same of Valeant CEO, Mike Pearson, whom they described as “exceptionally capable and shareholder focused… We think he is ideally suited to run a business that is at heart a value investor in pharmaceutical products.”15

  Sequoia described Valeant as “A pharmaceutical company that doesn't spend much money on research and development…. While Valeant doesn't spend much money on R&D, it does invest heavily in its sales force.”16 Valeant didn't spend much money on R&D because its business model relied not on creating new drugs, but buying existing ones and then raising the prices. For example, in 2013, Valeant bought Medicis, whose calcium disodium versenate drug was used to treat people exposed to lead poisoning. The original cost was $950, which Valeant raised to $27,000.17 Mike Pearson was certainly shareholder focused, but that is where he and Warren Buffett's similarities ended. Talking about Pearson, Buffett said, “If you're looking for a manager you want someone who is intelligent, energetic, and moral. But if they don't have the last one, you don't want them to have the first two.”18

  In September 2015, presidential candidate Hillary Clinton tweeted, “Price gouging like this in the specialty drug market is outrageous. Tomorrow I'll lay out a plan to take it.” In that session and the five to follow, Valeant shares fell 31%. Valeant was being punished for what many considered to be unethical business practices, but raising drug prices is hardly a rarity in the healthcare industry. What would really knock Valeant off its perch were accusations of fraud.

  On October 21, 2015, Citron Research published a report, accusing Valeant of accounting fraud and compared it to Enron.19 That day, shares collapsed nearly 40% before recovering and closing “only” down 19%. As a result of its huge position, that month Sequoia underperformed the S&P 500 by 17.47%! (The fund lost 9.03% as the S&P 500 gained 8.44%.)

  With Valeant shares down more than 50% from their highs and fraudulent accusations ripping across Wall Street, Sequoia put out a letter to its shareholders. “Its chief executive, J. Michael Pearson, has in our opinion done a masterful job of acquiring a broad portfolio of prescription drugs.”20 Of Pearson they said, “He has been aggressive every step of the way, and has attracted equally aggressive critics.”

  Sequoia didn't just say this to calm their investors, they actually believed it. So they did what value investors do when their stock gets crushed – they bought more. After this purchase, Sequoia became Valeant's single largest shareholder, and it represented 32% of the fund's assets. During the panic, invoking an old Buffett line, David Poppe, CEO of Ruane, Cunniff said, “Be greedy when others are fearful.” He also used Berkshire to defend his choice, saying that when Berkshire got crushed in the late nineties, it was 35% of the fund while the stock got cut in half. True, Berkshire recovered and was one of their best investments ever,21 but while the comparison might have made him feel better about buying another 1.5 million shares of Valeant, it did nothing to calm their investors.

  Michael Pearson is no Warren Buffett and Valeant is no Berkshire Hathaway. Thomas Heath from The Washingt
on Post described it like this: “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.”22

  Eight months after defending Pearson and Valeant, Sequoia would sell their entire position. Valeant lost more than 90% of its value in just a few months, and Sequoia, which had hitched its wagon to Valeant, saw its assets cut in half.23 An investor base that expected results had long replaced the patient investors that they began with in 1970. Losing 26.7% in a 12‐month period when the S&P 500 gained 4% was too much to bear. In 2013, Sequoia closed the fund to keep new investors out; as a result of the Valeant crisis, it could have used a lock to keep them in. In just a few months, Sequoia assets fell from more than $9 billion to under $5 billion. A single stock leveled one of the most successful funds of all time, you should think twice before putting yourself in the same type of situation.

  If you want to make big money in the stock market, you have two choices: (1) buy a lot of stocks, an index fund, for example, and hold them for a long time (even then, no guarantees) or (2) buy a few stocks and hope you're right. Sequoia was right for a long time, and then they were very wrong. Even with the Valeant debacle, their long‐term track record is phenomenal, but the point in all this is that if you are going to take concentrated positions, you must have the stomach for massively different results than the overall market. It's easy to look at long‐term charts of Microsoft and Apple in awe, but when you do, remind yourself of Valeant and Enron.

  There are a few things you can do to prevent yourself from marrying the next Valeant. If you are buying a chipmaker because you hope it gets into the next iPhone, write down your thinking. This way, if it doesn't come to fruition, you can combat the endowment effect, which is the phenomenon of people ascribing more value to something because they own it. Writing down the reason you bought something can mitigate this. The other thing you can do to prevent your own future self from getting stuck to a position is to write down an exit plan. For example, Let's say I am putting 10% of my portfolio in stock XYZ at $100, and I'm willing to risk 5% of my overall portfolio on this stock. Then you can back into the price at which you would cut your losses, in this case, all else equal, if stock XYZ falls below $50, you're out.