A Conversation With the Sequoia Fund's Managers
Two members of the Sequoia Fund’s investment committee open up about the firm’s culture, why the portfolio is more fully invested than before, Berkshire, and more
(A note to listeners: We recorded this interview before the recent sell-off took began, explaining why it’s not discussed. We’ll address the recent downturn in future installments of The Long View. Please enjoy this episode and thanks again for listening.)
Our guests this week are Arman Kline and Trevor Magyar of investment management boutique, Ruane, Cunniff & Goldfarb, or RCG for short. Arman and Trevor sit on the five-person investment committee at RCG that oversees management of all client assets, including those held in the Sequoia Fund. This year, the Sequoia fund will celebrate its 50th anniversary as a mutual fund. From its July 15, 1970, inception through Jan. 31, 2020, the fund gained 13.6% per year, topping the S&P 500 index by 240 basis points annually. Arman joined RCG in 2002, following a stint as an equity analyst at Merrill Lynch. He graduated from Colby College. Trevor began at the firm in 2007, following an early career in investment banking, private equity, and hedge funds. He's a graduate of Princeton University and received his MBA from Harvard University.
Ruane, Cunniff & Goldfarb (RCG)
RCG investment committee and team bios
Sequoia Fund 2019 Annual Report
Sequoia Fund Q4 2019 Investor Letter
Sequoia Fund shareholder communications
Morningstar analysis of Sequoia Fund; Aug. 8, 2019
Sequoia Fund portfolio analytics
Rolls Royce PLC ADR RYCEY
Zalando SE ZLDSF
Zooplus AG ZLPSF
Vivendi SA VIVEF
Berkshire Hathaway BRK.A
Jeff Ptak: Hi, and welcome to The Long View. I'm Jeff Ptak, global director of manager research for Morningstar Research Services.
Christine Benz: And I'm Christine Benz, director of personal finance for Morningstar, Inc.
Ptak: Our guests this week are Arman Kline and Trevor Magyar of investment management boutique, Ruane, Cunniff & Goldfarb or RCG for short. Arman and Trevor sit on the five-person investment committee at RCG that oversees management of all client assets, including those held in the Sequoia Fund. This year, the Sequoia fund will celebrate its 50th anniversary as a mutual fund. From its July 15, 1970, inception through Jan. 31, 2020, the fund gained 13.6% per year, topping the S&P 500 index by 240 basis points annually. Arman joined RCG in 2002, following a stint as an equity analyst at Merrill Lynch. He graduated from Colby College. Trevor began at the firm in 2007, following an early career in investment banking, private equity, and hedge funds. He's a graduate of Princeton University and received his MBA from Harvard University.
Arman and Trevor, welcome to The Long View.
Trevor Magyar: Thank you, Jeff. Thank you, Christine. We're happy to be here. Yeah, thank you.
Ptak: So, let's start by talking about how a firm strikes a balance between honoring its history while pushing to reinvent. Your firm has a very distinguished history but went through adversity a few years ago. Can you walk through your thought process for deciding what to preserve and what to change about how you invest and operate?
Magyar: We did go through a transition. I guess, every transition is different and has its own challenges and opportunities. In that respect, I guess our transition was no different. One thing we did have--there was a great deal of continuity. So, we weren't changing our investment philosophy. We weren't changing our investment process. And really, the kind of cast of characters is largely unchanged. So, Arman, joined the firm, I think, in 2002. I joined in 2007. I think of the Investment Committee, we've got nearly 100 years’ combined tenure at the firm. But there was a lot of work with, and a lot of continuity to work with, and I think we are really fortunate to have that.
So, the committee – as to the committee itself, and committee is somewhat of a funny and loaded term. We just prefer the word “team.” We think of the firm and the fund as being team-managed. We're happy to go into how that's working from a technical perspective. But if you look at the history of the firm over, I guess, almost 50 years now, the fund and the portfolio has been team-managed for the vast majority of that time. So, not only did the committee structure feel natural to us, it also felt like a return to our roots. And so far, it's working well, at least I think it is. Arman?
Arman Gokgol-Kline: Yeah, I agree with that. As Trevor said, we've got about 100 years of combined experience. We've all worked with each other for over a decade. So, while there was certainly a transition taking place in terms of leadership, we had been working together sourcing ideas, doing research talking about building portfolios for over a decade as a team. And so, there was a lot more continuity than from the outside it might first appear.
Ptak: That's helpful. So, if we were to look in and observe the way investment decision-making takes place now versus perhaps how it took place, let's say, before 2015-2016, I mean, what are the more striking differences? We know that there are certain controls and modifications you made to your decision-making process. For instance, I think that you have maybe a 3-to-1 majority rule that you require for ideas. There are also some caps to position sizes that you instituted as well. And so, those are obvious examples. Are there other things that we would notice about your decision-making process that changed?
Magyar: You know, I really think more has remained the same than has changed. The voting structure is important. I mean, you have to have it and these new sorts of caps we have on individual position sizes, again, it's important, I don't want to minimize it. But if you just look at how our research process works on the ground, day in, day out, week in week out, it really hasn't changed that much. We spend much, much, much more time researching than we do pulling the trigger, so to speak. And again, the committee, the team meets weekly, but we're talking and interacting on a daily basis. So, while something may come to the committee and we make a decision, it's not that often that it comes down to our sitting around the table and passing ballots. Most of the time, these decisions make themselves over a course of time. Like, we have a conversation about a particular investment, whether it's prospective or existing. And the work and the research takes us in a certain direction and there's no need to even have a vote. Of course, it happens now and again, and we don't all think alike and that's the whole point of having a committee. But the day-to-day cadence and the work process and the work product, it's really quite similar.
Kline: Yeah, I would just add, a lot of what we did is formalize things, such as how the committee would work, but to Trevor's point, these new things around the committee and the voting, were really just formalizing things we kind of did for a long time, whether it was our predecessors, even Bill and Rick, and then, you can add others who were kind of managing the funds many, many years ago to ourselves, and just making sure that there was just some formal understanding for that going forward.
Benz: So, when you went through the reset in 2016, and you formalized how the committee would work, and you set position size limits, you could have gone outside in terms of tapping talent, but you stayed with the team that you had largely. Why was that?
Magyar: Honestly, I think the majority of the members on the Investment Committee had previous portfolio management experience, in some cases, managing large sums over decades. So, I didn’t feel like we were lacking there, and this is the team that sourced and researched the vast majority of investments that were in the portfolio at the time. So, again, not to minimize the transition and the specific challenges. That wasn't the issue. Really, we felt we had plenty of experience. And it was really just a question of how to harness it and even that discussion didn't last more than five minutes. And we kind of knew right away that the committee was what made the most sense for us. And I mean, never say never, but I would be nervous about bringing in someone from the outside to play that role. It’s like Arman said, we've all worked with each other for 10, 15, 20 years, we know each other very, very well. We're all philosophically aligned. But it's interesting when we're in these meetings, and we're debating ideas, you realize, we're not all exactly the same. And while we may be 95% aligned, we're not 100.0% aligned. And that's the beauty of it, that we're different. But I got to say, if you're only halfway aligned with something, I fear that you would not end up having the most productive conversations. And I think we have a situation where one plus one is greater than two. And I really think the high, high degree of sort of philosophical one – and frankly, just personal trust is a big part of why.
Kline: Yeah, and I'd add that we talk a lot about our culture at our firm--and a culture is important to a lot of organizations--but it's especially true to ours and important to ours in terms of this ability to sit in a room, look across, have strong debates about investments, about companies, about risks that are viewed differently by different people. And if you're part of and ingrained in a culture that kind of encourages that level of debate in a healthy way, that's kind of the secret sauce that allows a committee or a team to work well. And so, there's a little bit of a danger to bringing someone from the outside who hasn't grown up within the firm and within its walls for a decade-plus, like all of us had, and inserting them into that process.
Ptak: I wanted to shift gears a bit and talk about the relationship that you have with your clients. I know that one of the things that you went through as a firm is you've had some redemptions of client assets, and with that came the decision to reopen the fund, and to do something that maybe was a bit less familiar to the firm, which is to market it for the first time in a long while. And I know that you probably put your own spin on marketing with maybe not an uppercase M, right? You go about it in your own way. But how did that inform some of the choices you made about staff and capabilities you felt you needed to invest in--the fact that you were going out and making yourselves and making your capabilities available to the market in that fashion?
Magyar: Right. So, I mean, first of all, for us, priorities number one, two, and three are long-term investment performance for our clients. Period. So, when we went through this transition, that was our primary focus, and we made investments in that area, and we can talk about it. Now, on the business side, our top priority was and is taking care of our existing clients. And so, over the past handful of years, we've actually made significant investments in our ability to service them. We've always offered them sort of high-touch service. But we needed some work in terms of reporting and systems and all the rest of it. And frankly, it was time to do it. And it's taken up a lot of time and effort, not necessarily on the part of Arman and myself, but other professionals that had been here and that we brought into the firm. And we’re really, really proud of the upgrades that we made here. We want to be good at everything we do, and that’s frankly an area where we knew we could do better. Arman, do you want to weigh in on the marketing piece?
Kline: Yeah. So, on the marketing side, the most important aspects of marketing at our firm, as you pointed out, once we opened up, was helping to effectively communicate how we think about investing, how we act as investors. We talk about this in other forums as well. But that's what we spend a lot of our time doing--is making sure that we have an effective way of communicating that to potential investors.
Magyar: Yeah, it's funny, you made the comment about the capital M versus lowercase m. It's true, like the whole idea of marketing, its present form to the firm, the firm really had almost no experience with it. But it didn't take us too long to come to the realization that, you know, not having the ability to form some number of new relationships with like-minded investors over time--that's not just bad for us, it’s bad for our clients. And so, I don't think we're ever going to be a marketing-oriented firm, but clearly, there's a muscle there that we had to develop. And we've made some investments in that area and seems like things are going well.
Ptak: And it seems like it also informs some of the choices you made about how you'll continue to make yourself available to the market in terms of--I know the industry terminology for it is distribution--you haven't got and entered into subadvisory relationships, you haven't gone and probably engage with other types of intermediaries, who are perhaps gatekeepers to capital. So, is it fair to say that you're committed to having the same type of relationship with your shareholder base that you did before while perhaps broadening access somewhat to the strategy?
Magyar: Yeah, I think that's exactly right. I mean, as I said, making sure that we have a strong link between ourselves and our clients and investors, that we're aligned in terms of how we invest, how we act as investors, how we think about investing, the time horizon involved, is just so crucial. And when you start getting into intermediaries, things like that can be a little bit tougher to communicate. So, that is certainly our North Star as we think about distribution. And so, like you said, I don't think we're going to have major changes there.
Benz: Switching over to the portfolio, Sequoia is nearly fully invested now, and that's somewhat out of character, as it was typical for 10% to 20% of the portfolio in the past to be in cash. You've said it's because you're finding enough attractive investments, but given that the fund is more fully invested, have you changed the way that you approach risk management at the individual holding or at the overall portfolio level?
Magyar: We basically sat down as a group, and we talked about things that the firm has done well and things that it could do better. And we just looked at the data. If we looked at the history of the firm, so nearly 50 years, the single biggest mistake--and by a wide margin, I might add--is holding too much cash. We're naturally conservative. I mean, we're kind of paid to worry. So, the attraction of holding cash is very clear to us. It's something that resonates with us. But when you look at the multidecade history, it's very hard not to conclude that we would have been better off, that our clients would have been better off, had we more confidence in our process. And so, that's the shift that we've made with the portfolio.
Kline: I think we also like the idea (indiscernible) that comes with more competition for capital. One thing we liked that was kind of a side effect to this idea of saying, look at the data, or stop thinking over many, many, if not most time frames, and certainly over the history of the firm suggests that we should run with lower cash levels. The other thing that comes out of it is every time you want to make a new investment, you're competing with capital coming in that’s already in your portfolio, which you obviously like enough to have in your portfolio, and the discipline that that starts to impose has been a benefit for us.
Benz: What about the peace of mind factor, though, that comes along with having cash to the extent that maybe that helped keep clients in their seats during various market environments--the fact that cash maybe smoothed out volatility a bit?
Magyar: I think it probably did smooth out the performance to some extent, just from a pure statistical perspective. And I've got to assume that some of our clients on like a gut level appreciated that. But again, we just think that the right thing to do for the clients and for the performance long-term is the trust to the process. When you start holding large cash balances, it’s kind of hard not to get around the conclusion that you're trying to time the market. And there are people out there who are probably good at that. I don't think we are. And if you look at the full history of the firm, we are better business owners than we are market-timers and that's the direction we’ve taken it.
Kline: Right. And I’d just add, we actually spoke about that and we basically just said, “If we are going to trade off a little bit higher volatility for a better return for our clients over time, that’s a trade-off that we're willing to make.”
Ptak: Do you think, though, that the cash is somewhat entwined with the performance that you've seen from the stocks that you've held, in so far that, in the past perhaps it's given you the fortitude as investment decision makers to stick with those names through adversity or to be as big in them as you have been in some of your most successful positions? Or do you think the two are completely separate?
Magyar: It’s an interesting question. I don't think of the two as particularly related. I mean, if I look at the portfolio, if I look at the top 10 and how much of the portfolio is comprised of that, I don't think it's materially different today than five years ago, 10 years ago. Arman?
Kline: No, I don't think so either. I mean, I think that the cash was there before. I don't think our predecessors would have been voting to take on larger positions or anything. I think they grew up in volatile markets where they had opportunities to deploy capital at very attractive rates before. And they were happy to try to wait for those periods. And I think the lesson we learned when we look at the data over 50 years is, while it may feel best to hold some cash, thinking, “Well, eventually when I get that opportunity, I’m going to deploy the capital”--the time that you're holding the cash to wait for that, if those opportunities come few and far between, there's a real cost to it. And the reality is, if we had just held all the investments we've held before, in larger size and held less cash over time, that we would have done better for our clients.
Magyar: Bill and Rick have a track record that I think anybody would be proud of. But if you go back and you think about how the firm was founded, it was in the fire of a really tough market in the 1970s and when it finally broke their way, they were buying some of the great American companies at single-digit P/E ratios. And I suspect that after that, the formative experience, it got harder for them to reach. And the history of the market from then to now is one of expanding valuations. I can't help but wonder if there's some way in which they maybe never got comfortable with it. But anyway, that's just a bit of the kind of history of the firm. Again, we're operating here in the now, it’s been a 50-year experiment. I think the results are pretty conclusive. And like I said, we're going to be more largely invested over time.
Ptak: How does your team make decisions about portfolio weights? So, just to choose an example, you bought an additional 4.2 million shares of Rolls-Royce on weakness, it appears, in the third quarter of last year. So, I'm curious how your team arrived at the decision to do that. I'm sure that you have a lead analyst, a key decision-maker on that, and there's a deliberation process that goes on. But in terms of sort of sizing that position, how did you come to the conclusion you came to?
Magyar: So, the Investment Committee makes all kinds of decisions whether it's an add, a trim, a buy, or a sell. So, in terms of just the mechanics, we all sat in a room and made that decision. In terms of the process, kind of how that was brought off, and the analysts, actually a couple on that project, before for the results came out, basically came out and said, “Guys, we see an opportunity here to make the investment larger. We think the market is giving us an opportunity.” We had a couple of debates at IC level about it. We had debates about if we wanted to buy more, how much more to buy. And again, that happens at the IC level along with the analysts involved. And it's really a trade-off between risk, between potential return, and between the conviction you have in the idea. And so, in Rolls’ case, we saw a very high potential rate of return, we saw risk, and we saw a good level of conviction, but not perfect. And so, we added a little bit but not a huge amount to that position because of that.
Kline: For instance, with Rolls, you had a situation where the stock had come down, people had questions about the near-term trajectory of the business given some of the developments there. Mastercard, the business had continued to perform very, very well like it has for a long, long time. And the valuation has just continued to expand. So, you noted the one, Mastercard. There’s actually been a few. That's not by accident. Mastercard is an incredible business. I mean, it's got to be one of the best business models out there. Now, at some point, the math starts to break down. But I think to the firm's credit, we didn't and we haven't rushed out of this position because the quality is just so high. And instead of making a decision on one specific day, where we say, “OK, we've hit some target price. We're going to sell out of this incredibly successful investment right this minute,” we've made a series of smaller decisions. And I think making a series of smaller decisions in terms of exiting Mastercard, or trimming Mastercard, is a much better way to go, not just because it's a way to kind of reduce the risk of any single decision, but it keeps us in a much healthier position psychologically in terms of how we manage positions going forward.
Benz: Speaking of the whole portfolio, the portfolio isn't necessarily cheap by traditional GAAP accounting measures, and you yourselves have acknowledged that the portfolio is trading at what you say is a modest premium to the market. So, given this--the fund’s success will turn on whether your holdings outgrow the expectations imputed in their current prices--how is that not growth investing? Or would you say it is growth investing?
Magyar: Yeah, I don't know if we would say it's growth investing or value investing. We read the papers, and we talk to our peers in the industry, and we know there's an active and very interesting debate around growth versus value. I'm just going to tell you that that debate is not one that you'll hear inside these four walls now or, frankly, ever. It's just, we don't think about it that way. We're obviously looking to get more than we give and that's it.
Kline: Yeah, I mean, for us investing--and we call it value investing--is simply buying assets for a large discount to its intrinsic value. And we're just as willing to buy a growing business that trades for a high GAAP P/E like an a2 milk at what we deem to be at big discount to its intrinsic value as we are a slower-growing organic business such as Jacobs at what we deem to be as large discount to its intrinsic value. And so, we really don't spend a whole lot of time talking about, you know, whether something is a growth investment or a value investment. We just think of all things as, are we, to Trevor's point, getting more than we're giving.
Magyar: I mean, this is maybe more nuanced than you'd like. But you know, all else equal, there might be a slight preference for high-quality businesses that grow because, in our view, that kind of makes time your friend. If you have something that doesn't grow and you buy it at $0.80 on the $1, you're really just betting on a convergence of the true price. But then at the end of the day, what do you own? We’d rather buy the $0.90 dollar that compounds over a decade. And if you look at the history of the firm, the big, big winners have been those sorts of investments. But again, we really resist the labeling of growth versus value. And I think if the opportunity set changed significantly, we could end up with a very different-looking portfolio in terms of fees.
Kline: I wouldn't be surprised at all, or either way, I could see the GAAP P/E as a firm go down below the market in five or six years’ time if that's what the market gave us as an opportunity.
Ptak: I think in some of the communications to shareholders, you've cast doubt on the notion that indexing is making it tougher for stock-pickers to add value. What you have said is that indexing has increased correlations, creating a dynamic where stocks could go on sale and in bunches, as you put it. And so, I'm curious: Have you taken steps to adapt your stock-selection process to this dynamic, so, should the market present you with opportunities in bunches, you would be in a position to capitalize on that?
Magyar: Right. So, I think if the future unfolds in the way you just described, where you have more episodic or large episodic moves in the market, we're going to have to be quick, in addition to being decisive. There's no structural reason we can't do that. That's just not what the environment has demanded of us in the past. I don't think there's any structural changes we need to make. I think we just need to be cognizant of the environment and recognize if and when this moment arrives, we’ve got to recognize the moment for what it is and react accordingly. But you know what, honestly, this is all just one hypothesis about how the future might look. But we’ll have to wait and see.
Kline: Right. And just to get a little bit of inside baseball here, I mean, we do have a farm team that we keep up. So, in addition to working on investments that are currently interesting, we have projects we've done over many years here at the firm, where we continue to follow them. We have analysts actively publishing on them. We have prices at which we are willing to engage with them. And so, we have certainly made sure that we are ready to act on that if the market in fact gives us a big sale of five, 10, 15 businesses that we're interested in instead of one, two businesses that we're interested in.
Ptak: You have 26 names in the portfolio, or at least you did as of 12/31/2019. And so, if you had to estimate, ballpark, how many names sort of wait in the wings where you've done the work on and if they got cheap enough and interesting enough, you would go and deploy capital into those. I mean, how many are we talking? Is it a few hundred?
Magyar: I'm not even sure what the exact number is. And the reason is, there are some companies that we've spent years looking at that and we have guys looking at right now, and there are other companies that we've looked at in a more casual way. So, I think it would depend on where you draw the line. But I can tell you it’s hundreds of companies. You know, (indiscernible) younger guys who would say, “I don't what to look at” and they would say, “You know, I don't know what to screen for,” and they start screening for just names they hadn't heard of. So, again, we have plenty of actionable ideas. I think, really, if there were a big move in the market, and we had to react quickly, were not the quality of the decisions about actual ideas…
Kline: I think we challenge ourselves on the investment committee, the investment team, to make sure that we're nimble enough to do that. But we worry less about whether or not there's going to be a lot of ideas floating up in those moments.
Magyar: We add a lot of elbow grease over here.
Benz: In that vein, let's talk about incentives that you give the team to keep an eye on some of those names, even names that don't necessarily get added to the portfolio. How do you motivate them to conduct good due diligence on those companies that may not enter the portfolio?
Kline: People here are assessed on the quality of their work and analysis, first and foremost, not on how many investments they get into the fund. And that is a qualitative analysis. It's also one that we as a group over many years make. What's important, and I think, actually, a good example is, we were talking about this at the end of last year, one of our colleagues had the best year in his career, I think it was in '17, and he got zero investments into the fund, he had three amazing projects that he did, and he convinced us not to buy one. And to us that was his absolute, the pinnacle of his career here so far, and he's been here for over a decade. So, we really do not encourage people to think about getting things into the portfolio as a measure of success. We are students of business, and the quality of the work you produce and the analysis that you produce is really how we judge each other. And frankly, that is not something you can even measure over a quarter or a year in our estimation. It's something we measure over time.
Magyar: If you think about our average holding period, which I think right now is somewhere between five and 10 years, it should be obvious that one year is a small fraction of just a single holding period. How can you judge anybody over that kind of period? So, we don't. And as easy as it is to say that that makes sense, the trick is to walk the walk, right? We can tell people that we're not going to compensate you or recognize you based on what goes in or out in a given year, or how a stock that you got into portfolio does over a quarter or a year, but then you’ve got to live it. And everybody around the firm has to know that when we say it, we mean it. That's something we take very, very seriously.
Ptak: You mentioned this analyst dissuaded you from making a purchase, which I assume that name went on to underperform. There were a couple of other projects, which you indicated were very compelling. Can you just give a flavor for what made them so? What was so distinguished about the work that this analyst had delivered to you, even if it didn't culminate in a purchase?
Kline: Yeah, sure. You are right that the one that didn't get in did not perform as well. And this analyst's ability to--frankly about halfway through the project as things were going well—recognize there was a changing fact pattern and very quickly pivot to that changing fact pattern was very good. In terms of the other two projects, for us quality of work is really about initially understanding a business, what makes it tick, and then going out there and spending weeks, if not months, talking to people in the industry, talking to people who have worked with the leadership of a company, talking to competitors, suppliers, whoever it might be, all these folks that are out there, to really help us understand what makes this business tick over the next five or 10 years, what are the threats, what are the opportunities. And you can kind of see this mosaic coming together, and in the best of projects, you just have a large body of work that starts to feel like you're checking all the boxes, you're starting to understand the known unknown, and the set of unknown unknown starts to shrink on you, where you are saying to yourself, “Gosh, I think there's still stuff here that we're not so sure of.” And so, that's really how we qualify and quantify whether (indiscernible) well done.
Magyar: This is what we do. I mean, if the question is, “Well, gee, how do you measure or gauge or set the project if you don't even end up buying it?” All of us, including the folks on the Investment Committee, spend the vast majority of our time researching companies, researching them from a primary perspective. And that means reaching out to competitors, reaching out to customers, reaching out to suppliers, reaching out to the people who used to work in the company and trying, like Arman said, to understand what makes the business tick. And we have a very specific way of recording all of that information in a form that everybody around the firm can digest and sharing that and discussing it, and it's fascinating. When you do this enough, you can tell when a good project is coming together, right? Like, you say, “Well, I don't know, that seems like a hard issue to due diligence.” Well, go talk to 100 people over the next three months, and let's see what you learn. And often, you learn things you didn't think you could. And so, this is our craft. We know what good looks like. And it's really the lifeblood of the firm. And people know that.
Kline: Yeah, we had a colleague that came over kind of later in his career than some of our younger analysts, when he start on some of work, he'd say, “Oh, gosh, I'm not sure that's knowable.” And we say, “Well, just go through these phone calls and come back to us in a few weeks or months and let's talk about it again.” Obviously, we read the work as it was ongoing. And he was saying to us, at the end of last year, “Gosh, you guys opened my eyes to the fact that if you just go and talk to enough people, you're going to start to get a feeling for what's really going on here.”
Benz: You've used the term “project” a couple of times, and I'm just wondering if you can give us a tangible example of a project. Is that researching an industry, or how are you using that term?
Magyar: Right. So, usually, we're researching a company. We tend to be more bottom up than top down. And it's usually coming from one of our colleagues. We toss ideas out for sure if we have them and then suggest that people work on it. But usually, it's coming from one of the analysts. And the reason we call it a “project,” not an “investment,” is we are keenly aware that while we are measured in terms of performance of the stocks over the long term, ultimately, we are in the process business and the judgment business. And so, we look around at our team and we say, “OK, we need as a team to source some number of interesting ideas, research them thoroughly, make decent judgments, and perhaps make a few investments this year.” Across a dozen or more people, that's not actually a lot of investing activity. It's a lot of research activity. So, we kind of call them “projects” because that's what the machine is fueled on. That's what drives the engine.
Ptak: I wondered if you could take us through the bear case for CarMax, which is a name that you've been in for some time. What in your research has mitigated those concerns enough to satisfy you that it's worth continuing to own?
Magyar: CarMax is really interesting. When we made the investment, there were several online used-car startups out there lurking. And we've researched them at a time, but it became pretty clear over the next one, two-plus years that one was rising above all the others, and that's Carvana. And we're paid to worry. So, that's what we did. We got worried. And we said, “Well, let's go look at Carvana.” So, we went to school on Carvana. We actually had very, very good things to say about Carvana. It really kind of pioneered the online space. There are questions about whether or not the business itself is going to scale into their expense structure. And people had different views on that. But the point is, they proved that the customer wants this--and that was something that people debated. They said, “You know, maybe customers don't even want…” They do, and Carvana has proved it, and they proved there's power in that model.
So, what we did was a full project on Carvana. And putting aside what our specific views were on that company, it did give us a really good view on what CarMax is doing, what they're planning to do there, and how we feel about it. So, long story short, given the nature of this business, this is not likely to be a winner-take-all market like certain other e-commerce markets in our view. It doesn't mean that people who are able to develop strong online offerings won't garner lots of share. We think they will. We just don't see it being the case that Carvana is going to run away with the entire used-car market, which is in the hundreds of billions of dollars and, unlike books, for instance, involves very, very unique inventory. So, the real question for us is: Is CarMax learning? Is CarMax developing its own online model, and does the omni model work? Because that's going to be the big difference for CarMax vis-à-vis Carvana. They're going to have an online offering or they do have an online offering that they're rolling out right now. But they also obviously have physical stores. And basically, we were convinced that they’re going to make the transition. And it's a big transition--it's the biggest transition CarMax has gone through since the company's founding in--I think in the early mid-1990s. But it's quite possible that we're sitting here five, 10 years from now and we say, “Wow, that was tough, but that was something that really deepened and widened the moat.”
Kline: Right. And I think, as we, to Trevor's point, did more and more work on Carvana and this online model as a threat to CarMax, we in fact started to get more and more optimistic about the fact that there were not a lot of established players in the used-car market that maybe were positioned to make this type of a transition to an online market. And yes, Carvana is the pioneer in this kind of the pure play. But gosh, CarMax is pretty well positioned and as an organization has made a decision to move towards the online omni model. And there are going to be a lot of players in that market by our estimation that might struggle with that. And so, this concern started to become more of a focus on an opportunity that obviously we believed in doing the investment.
Magyar: This was a research journey, and it was an emotional journey. Obviously, as Carvana arrived, you know, we said, “We've got to figure this out.” And we had no preconceptions. We kept an open mind. We weren't looking to defend our thesis. But when we came out the other end months later, as Arman said, we came out feeling actually quite good about CarMax.
Ptak: I think Jeff Bezos said, and I believe you've quoted this in your materials--your margin is my opportunity. And so, as you scan your list of holdings, where do you think those vulnerabilities are where you've got some businesses that are endowed with very significant competitive advantages that have allowed them to scale and really margin their businesses? But there are competitors waiting in the wings, looking to take some of that margin away, capitalism being what it is. Where do you think that some of those vulnerabilities are maybe most serious, and what's an example of some work that you've done to buttress your confidence that it won't waylay the names that you own that are like that?
Magyar: CarMax is one where we basically gotten comfortable with that risk. And the reason I think really stems from the nature of the product; every car is unique. That's number one. Number two is: Even in a pure online model for used cars, there's an awful lot of what you would call bricks and mortar. So, that's when we don't see getting low on the risk in terms of threat from Amazon. There are other holdings that we exited. We came to a different conclusion where we had high-quality businesses that we'd invest in for a long time quite well for us where we couldn't convince ourselves that they weren't at risk for the very reason you mentioned. And we've exited. And it's interesting, (indiscernible) those companies have gone on to do not so great and others quite well. And only time will tell whether our judgments were right in terms of the long-term threat that they're under.
Kline: To Trevor's point, we have gone through that exercise, especially in retail, where it's kind of most pronounced, and many of the investments that we've sold over the last three-plus years have in fact been sold because, over the near term, it was hard to tell where the margins going to go over time. This exact concern that there was some overearning potentially going on, that there's certainly a pricing umbrella or margin umbrella for someone else to come in.
Magyar: Yeah, and what we always worried about wasn't so much the direct Amazon threaten, I mean, Amazon taking over the market. But Amazon doesn't need to become very big in any given market to drive lower prices.
Kline: In terms of current holdings, I just thought of one which is Vivendi Universal Music Group, which is a kind of an established label. And there are certainly changes happening in that market, both on the distribution side and on the label marketing side. And we spent a fair bit of time trying to make sure that we are comfortable with the idea that the labels continue to hold a unique position in the distribution, marketing, and creation of music, so that the margin that they are earning is not going to be under pressure. That's probably the one that kind of comes to mind the most in terms of this debate we're having today in the portfolio.
Magyar: But … we spend a lot of time talking to some clients who ask us, “How do you get comfortable with technology and is that within your circle of competency (indiscernible)? We spend as much time talking about technology with respect to our nontechnology companies as we do with respect to our technology companies. I just don't think you can get around it. So, these are all good questions. And we're constantly asking ourselves which companies are (indiscernible). But again, the interesting thing is, while we made active investment decisions because of this risk, the jury's still out. In some cases, I think we were right, but I'm not sure, we'll have to see.
Ptak: I did want to ask you about, since we're on the topic of Amazon, your thesis for online home furnishing retailer Wayfair has provided management executes it can coexist in its category with Amazon. I think you said something to the effect that decorating one's home isn't the same as buying laundry detergent. That's true. And so, I wonder if maybe you can cycle through some examples of firms that had been able to successfully coexist with Amazon in their category. I think that you alluded to some, but maybe are there some specific examples that come to mind?
Magyar: Yes, there are examples. You have Zalando in Europe. It's a pure e-commerce player focused on apparel, which actually in some ways is similar to home furnishings. There's Zooplus, again, a player in Europe that focuses on pet supplies. You got Petfive in the U.S., which is, I guess more of an omni player. But again, it's kind of hanging in there with Amazon. It's a very interesting story.
Getting to the heart of your question, the fact is very few companies have really stood up to Amazon. So, there's no doubt about it. We are making a stand here. We're making a call with respect to Wayfair. And we have a great deal of respect for Amazon, we own it, and what they have done, not just in terms of the size of the retail business they've created, but the pressure that they put on the whole retail ecosystem is nothing short of extraordinary. So, let's just start with the fact that it's a great question. It's one we ask ourselves. Now, as we were studying Amazon and the analogs of Amazon throughout the world, it did occur to us that as powerful as some of these giant ecommerce platforms are, there might very well be opportunities for specialist players to thrive or at least in any case survive. So, I would just say as a general thing, we've been looking the world over for those sorts of specialist players. And in Wayfair, we believe, we found one.
Kline: I would just add that one reason we started to get interested in this idea that Wayfair might be a specialist that could thrive in their kind of vertical was that, first, it was an interesting category. It's really more browsing-driven than pure transaction. So, Amazon has proven to the world that if you want convenience, fair pricing, and very fast delivery, they're a wonderful solution. So, if I know I want to buy a pack of AA batteries, I'm going to probably go to Amazon.
Furniture is different. A) It's not really a branded category. I mean, sure, there are brands out there, but it's mostly an unbranded category. And then, B) the way that people tend to buy furniture is more of a browsing experience where they tend to look, “OK, I want to buy a dining room table or a dining room set and we look at different options. Maybe I want to think about how I'm going to decorate that room with also a rug and some side tables.” And so, it tends to be a longer purchasing process that's really focused on browsing. We have this unbranded nature, which means that the vendor base tends to be a little bit weaker. And you also have the fact that browsing is so important. We felt that that might be a setup for a category where, in fact, there's enough differentiation from Amazon that we think there's room for a strong second player.
Magyar: It's also a giant category, right? It's got multiple hundreds of billions of dollars. Like Arman said, it's really browse, not search. They're not comparing, you know, pennies down to the penny across the site. I should also add that Wayfair is, we believe, one of the highest-quality performing marketing organizations in the world. The history of the company is interesting in that respect. I think the two founders started operating not just one site, but dozens and dozens of sites, selling all sorts of things, the things like Hatrack.com and all these other crazy reselling sites in the early days where the business ultimately migrates to home goods and they rebranded to Wayfair, but they cut their teeth in a very, very tough environment. And they've proven very adept at that. We think that's also an important part of the investment.
Benz: We want to talk about Alphabet, which is the fund's largest holding. It was about 12% of assets as of the most recently available portfolio. So, we're wondering if at a high level, you could walk us through what the market is missing in the way it prices Alphabet shares, especially considering that it’s sort of the most closely followed firms in the world and it has outperformed the S&P. So, can you talk about what you think your competitive edge is there? Is it time horizon, and what gives your firm an analytical edge in looking beyond the market's typical horizon?
Magyar: With Alphabet, we can talk about the specifics of the business, but just one high-level thought is, I'm not exactly sure what our edge might be, and I don't know that we were sure exactly what our edge was when we made the investment back in 2010. It was already at that point a $100 billion company, and I think it's now compounded for us at 20% since we made the investment. Our guiding light is not to seek out a differentiated view versus consensus, whatever that is. That's a strategy, that's, I think, what many investment firms do and do it profitably. It's really not what we do. We just look at the facts and try to develop our own view, our own projections, and our own sense of the business and just make decisions that make sense to us. In some cases, we find ourselves making an investment that seems like the rest of the world agrees with us. And frankly, Google back in 2010, at that point, was one of one of those investments. I mean, there was some concern at the time about the shift to mobile, but it was a well-known and well-loved company even then. We just seek out what we seek out. I don't know if that's helpful. I mean, Arman, when you talk specifically about Google…
Kline: Yeah, sure. And so, one thing that's important to probably note here is, yes, Google is our largest investment. But it's really a trade-off between return, risk, and conviction that we have that the business can compound over a long period of time. And when you look at those three factors, we do feel like Alphabet for a while now has been an attractive business to invest in. Duration is certainly a part, but we do think it's one of the best businesses that we have certainly seen in this organization over a long period of time, the core search business, their ability through YouTube to build second, third leg, Android and now, to a much lesser extent, cloud, but they're also going into cloud business. And then, obviously, they have some options out there in things like Waymo, their self-driving car unit, which today are obviously cost centers, which in the future might have a real value associated with them. But again, just coming back to that core search business, I think we feel pretty strongly that that's a very high-quality business, and we have pretty good conviction around its future.
Magyar: We're paid to worry. So, there's plenty to worry about with Google. Regulatory risk that people talk about a lot. It's also the case search business is more mature than it was two years ago, five years ago, 10 years ago. So, all those things figure in, but we try not to lose the forest for the trees. And like Arman said, when we step back and we look at Google, we see one of the best business models we've ever seen. It's still growing, not at the rate it used to grow, but we like what we see.
Ptak: We'd be remiss if we didn't touch at a high level on Berkshire Hathaway. Your firm has had a long and very profitable association with Berkshire spanning more than three decades. My question is--operations and decision-making. What are your impressions of how that will work going forward? The firm is obviously very, very large and by many measures complex. And so, operations and decision-making have been highly decentralized to this point. Do you think that it will remain a signature aspect of Berkshire going forward?
Kline: You know, it's a good question. Certainly, the capital allocation has been very centralized and frankly, for very good reason. You have arguably the greatest capital allocator of his generation at the top there making decisions. And I think we've all been quite happy over his career to let him do that. Whether that's the case going forward, it's hard to know where the capital allocation goes from an operational standpoint. I think there will likely be an operating CEO that kind of oversees the businesses. And so, there might be a little bit less decentralization there. It's really hard to know exactly where that all falls out over time.
Magyar: And there's clearly some uncertainty about what comes next. There's often uncertainty about how things will evolve in the future. But the issue here is that you have to add Warren Buffett--who's got the benefit of having Warren run the company and allocate capital so well for so long--so like, it feels like anything is going to be a step down from that. However, he does have a function to find businesses and just to bring it back to brass tacks, the valuation just simply isn't that demanding.
Ptak: What about decision-making speed? That's another hallmark of Berkshire is they make decisions thoughtfully but also very quickly. Do you think that one of the things that they'll perhaps have to consider in the future to the extent they haven't in the past is divesting what they would consider to be noncore assets just to ensure that they can continue to make decisions and deploy capital as successfully as they have in the past?
Magyar: Well, if any sort of transitions happens right now, I don't think they would need to be divesting noncore assets to retain cash. I mean, we have the opposite issue at the moment. Whether anybody will be given or want to be given as much flexibility as Warren has enjoyed and deserved for all these years, I don't know.
Ptak: And then, I think that part of your thesis based on your public comments, Johnny Brandt is, I think, your lead analyst. He's one of the analysts at the Berkshire meeting who ask questions of Mr. Buffett and Munger. Part of his premise is that a key to Berkshire's return on equity being satisfactory is whether they're able to deploy their excess cash. And so, obviously, that must figure into your thesis for Berkshire for the future. Have you formulated assumptions for how they will invest that? How do you get confidence that they will put that excess cash to work for fully apart for the fact they spend a massive amount…
Magyar: …(indiscernible) we play around with the numbers, we've looked at the cash holdings, we figured how much of that they might deploy at what sort of rates. And I guess, I would say, if a lot of it is deployed well, you could have a surprisingly good result. If not much of it is deployed, I don't know you have a great result; I don't think you have a terrible result either. And so, that kind of plays into the sizing as well. Arman made the point that position sizing is a function of return, risk, and conviction. I'm not sure that we think Berkshire is our highest-return opportunity, but it could do quite well. And we have a pretty high conviction that it's going to do better than the market.
Kline: I would just add, Warren does have a history of being shown opportunities that frankly, many in the market are not, and we think '08-'09 is a prime example of that. And so, there's certainly an outcome here where he has some opportunity over the coming years to deploy significant capital in a very attractive way. And if that is the outcome, I certainly think to Trevor's point that our results here might be better than satisfactory.
Ptak: Well, Arman and Trevor, this has been a lot of fun. We really appreciate your time and your insights. Thanks so much for spending time with us on The Long View.
Magyar: Thanks, Jeff. Thanks, Christine.
Kline: Thank you.
Benz: Thank you both.
Ptak: Thanks for joining us on The Long View. If you liked what you heard, please subscribe to and rate The Long View from Morningstar on iTunes, Google Play, Spotify, or wherever you get your podcasts.
Benz: You can follow us on Twitter @Christine_Benz.
Ptak: And at @Syouth1, which is, S-Y-O-U-T-H and the number 1.
Finally, we'd love to get your feedback. If you have a comment or a guest idea, please email us at TheLongView@Morningstar.com. Until next time, thanks for joining us.
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Christine Benz does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.