What The Sequoia Fund Teaches Us About Long-Term Investing

For those of you who are students of stock market history or have been on the investing block for a while, you may know that there was a period of transition between when Warren Buffett ran his private partnership for select investors and when he began using Berkshire Hathaway as his wealth-building vehicle.

During this period of transition from a partnership to Berkshire, Warren Buffett became disillusioned with the high prices in the stock market at the time. During the late 1960s and early 1970s, the major firms in the stock market were going through their “Nifty Fifty” days. This was a wild time when Coca-Cola traded at 40x earnings, Johnson & Johnson traded at 30x earnings, Pfizer traded at 28x earnings, and even Procter & Gamble traded at 28x earnings.

Buffett had no desire to invest new money in such an environment, so he shut his partnership down with the recommendation that his old partners invest in something called The Sequoia Fund.

If you followed Buffett’s advice, you were in for a bumpy ride at first:

In 1972, the Sequoia Fund only went up 3.62%, while the S&P 500 went up 18.98%.

In 1973, the Sequoia Fund lost 24.80% of its value, while the S&P 500 only declined 14.72%.

It was not until 1975 and 1976 that the Sequoia Fund came roaring to life. The fund appreciated by 61.84% in 1975, and 72.37% in 1976, while the S&P 500 went up only 37% and 23% in those years respectively. If you followed Buffett’s advice and purchased shares in the Sequoia Fund in 1972, you would be up 33,055% today, while the S&P 500 is only up 7,651% today.

Translation? A $10,000 investment in the S&P 500 in 1972 would be worth $765,100 today. A $10,000 investment in the Sequoia Fund back in 1972 would be worth $3,305,500. That’s over 4x as much wealth. But in order to achieve that, you had to stick through years of underperformance—the Sequoia Fund did terrible in relation to the S&P 500 in the early 1970s, and on average, has underperformed the S&P 500 anywhere between two and four years each decade since then. Yet over the long term, this fund has delivered.

There is an important lesson here—when you are executing your strategy and see other folks getting rich faster than you, or see that your stock is delivering disappointing returns, it could be foolish to abandon your strategy. You need to look at business performance, and make conjectures about future cash flow generation, to determine which companies are right for you. You should not look to see how you are doing against “the market” in a given day, week, or even year to determine the validity of your strategy.

Since at least 1997, Wal-Mart has been increasing its sales per share, cash flow per share, earnings per share, and dividends per share. You could see the company growing right before your very eyes! Yet, if you looked at the stock price, it stagnated in the $50s and $60s despite the business growth. For long-term investors, this should have been a pretty good signal that the market was undervaluing the stock, and it would be a good idea to buy.

We saw the same thing with Johnson & Johnson and McDonalds. McDonalds was getting blasted in the early 2000s in various media outlets for its unhealthy food options, yet if you looked at the balance sheet, you could see that the earnings were growing. And if you held the stock, the company deposited more cash in your checking account because the company raises its dividend every year. In the case of Johnson & Johnson, everybody freaked out because of the product recalls. But if you looked at the company’s finances, the cash flow per share was actually accelerating at a 8-9% rate because the company had purchased Jenssen Pharmaceuticals. If you observed what the company was doing, rather than what the media was reporting, you would have noticed that there was nothing to worry about. Oh, and Johnson & Johnson would have given you a dividend increase, which it has been doing every single year since JFK was President.

The fun part of dividend investing is that, during the years of underperformance, your stocks act like coiled springs. For instance, I own BP in the low $40s but believe it should trade between $55 and $65. The company currently pays a dividend around 5%. While the stock hangs out in the $40 range, I can reinvest those dividends at an attractive price, and then when the price of the stock rises to the $60 mark, I will have those reinvested dividends baked in at the $40 price range. For me, it’s a great way to turn inevitable underperformance into a future strength.