“There are, broadly two ways to behave as an investor. First buy something cheap in anticipation of a price rise, sell at a profit, and repeat. Almost everybody does this to some extent. And for some fund managers it requires, depending on the number of shares in a portfolio and the time they are held, perhaps many hundred decisions a year. Alternatively, the second way to invest is to buy shares in great businesses at a reasonable price and let the business grow. This appears to require just one decision (to buy the shares) but, in reality, it requires daily decisions not to sell the shares as well! Almost no one does this, in part because it requires patience.”
“The runway ahead for our businesses may be very long indeed. Inaction on our part is counter-cultural and deliberate, and is easier said than done. Really… As Berkshire Hathaway Vice-Chairman, Charlie Munger says, you make your real money sitting on your assets!”
The Value in Mistakes
"In investment terms, once lessons have been learnt, mistakes can be put on a price earnings ratio of one and the resultant, good behaviour on a ratio of more than one. In other words, mistakes become net present value positive."
The Real Mistakes
“The biggest error an investor can make is the sale of a Walmart or a Microsoft in the early stages of the company’s growth. Mathematically, this error is far greater than the equivalent sum invested in a firm that goes bankrupt. The industry tends to gloss over this fact, perhaps because opportunity costs go unrecorded in performance records.”
Recognising & Weighing the Right Information
“What investors needed to understand, and attribute sufficient weight to, in order to hold Colgate-Palmolive shares for the last thirty years, and so enjoy the fifty-fold uplift in share price, was the economics of incremental products (often referred to as “line extensions”, from the first “Winterfresh” blue minty gel in 1981 to “Total Advanced Whitening” today) and the psychology of advertising. Other items were important too, discipline in capital spending in particular, and there were lots of other things that seemed important along the way (stock market crises, country crises, management crises and so on) but it was the success and economics of line extensions and advertising that, in our opinion, was what the long-term investor really needed to embrace. A similar story can be told at Nike and Coca-Cola (manufacturing savings funneled into dominant advertising) or Wal-Mart and Costco (scale savings shared with the customer). Recognising and correctly weighing this information in-spite of the latest news flow is a matter of discipline, and it is that discipline that is so richly rewarded in the end.”
Risk with High Margins
"The risk with super-normal profitability is that profits are an incentive for a new competitor, far better to earn less, but for a much longer time.”
“We are genuinely investing for the long term (few are!), in modestly valued firms run by management teams who may be making decisions, the fruit of which may not be apparent for several years to come.”
Our most profitable insights have come from recognizing the deep reality of some businesses, not from being more contrarian than anyone else.
“Our job is to pass custody of your investment over at the right price and to the right people.”
“Almost ninety percent of the portfolio is invested in firms run by founders or the largest shareholder, and their average investment in the firms they run is just over twenty percent of the shares outstanding.”
“The best entrepreneurs we know don’t particularly care about the terms of their compensation packages, and some, such as Jeff Bezos and Warren Buffett have substantially and permanently waived their salaries, bonuses, or option packages. We would surmise that the founders of the firms Nomad has invested in are not particularly motivated by the incremental dollar of personal wealth… These people derive meaning from the challenge, identity, creativity, ethos (this list is not exhaustive) of their work, and not from the incentive packages their compensation committees have devised for them. The point is that financial incentives may be necessary, but they may also not be sufficient in themselves to bring out the best in people.”
Scale Economics Shared
“Nomad’s firms are, on average, so cost advantaged compared to many of their competitors that the worse it gets for the economy, the better it gets for our firms from a competitive position.”
“The simple deep reality for many of our firms is the virtuous spiral established when companies keep costs down, margins low and in doing so share their growing scale with their customers. In the long run this will be more important in determining the destination for our firms that the distractions of the day.”
“Scale Economics Shared operations are quite different. As the firm grows in size, scale savings are given back to the customer in the form of lower prices. The customer then reciprocates by purchasing more goods., which provides greater scale for the retailer who passes on the new savings as well. Yippee. This is why firms such as Costco enjoy sales per foot of retailing space four times greater than run-of-the-mill supermarkets. ‘Scale economics shared’ incentivises customer reciprocation, and customer reciprocation is a super-factor in business performance.”
"In the office we have a white board on which we have listed the (very few) investment models that work & we can understand. Costco is the best example we can find of one of them: scale efficiencies shared. Most companies pursue scale efficiencies, but few share them."
Price Give-Back
“We would suggest that investment in price-giveback, so favoured by Nomad's firms, is the most long-lived of the investment spending items if it engenders consumer habit. It may, therefore, be the most valuable to long-term investors.”
Compounding Machines
“We can do better with the compounding businesses these days- and they are much less stressful.”
“If we had out time again, we would hope not to be seduced by some firms (apparent) economic cheapness but weigh more heavily their DNA, if you like. One of the things we have learnt over the last few years is our most profitable insights have come from recognising the deep reality of some businesses, not from being more contrarian than everyone else. Old habits die hard but, even so, I am finally attending classes at CBA, Cigar Butts Anonymous!”
Misunderstood
“[We] invest in firms that are misunderstood by many. For example, we invest in firms that pay their employees 80% more than rival companies (Costco); firms that lower prices as an article of faith (Amazon.com); firms that force an equitable distribution of commissions in an industry dominated by an eat-what-you-kill culture (Michael Page); a low cost airline for the masses in a region served by airlines for the rich (Air Asia); and a company that thinks table top figurine games are cool, really, (Games Workshop). Isn’t it wonderful that these firms are behaving in this way despite being misunderstood by the outside world? All the social pressure will be to conform with industry norm but these companies have a deep keel that keeps them upright.”
Update from Sept 24, 2022
From @heymaxkoh on twitter:
Know how much is enough. What is your X amount ? There is wisdom in showing restraint. Don’t wear yourself out just to make more $$.
Destination analysis: what direction is the company headed in?
Only a few things in life are knowable.
The trick to be a successful investor is: 1) identify the sources of durability 2) get in early (while they are still developing the moat 3) own enough to make a difference to your wealth
Customer happiness:
Invest in founders and leaders who behave like owners of a private firm. Long term thinking is more present in them.
Scale economies shared: where a business shares its growing scale and dominance with customers…in the form of lower prices.
Maximizing profits do not always lead to the best long term outcomes. Instead reducing profits is a way to make yourself “hard to compete” against.
Competitive advantages can be many small things…combined. It makes you harder to copy.
Information has a shelf life.
Inverse relationship between attention and # of stocks you own.
You lose more money from selling great companies than you do from losing companies.
Company culture and customer happiness is the most enduring quality you should pay attention to:
Invert your position sizing.
Not doing anything is an active investment decision.
Update Sept 21, 2022
Full collection of Nick Sleep’s Nomad Letters can be found here:
https://igyfoundation.org.uk/wp-content/uploads/2021/02/Full_Collection_Nomad_Letters_.pdf
From Thomas Chua https://steadycompounding.com/investing/sleep/
Nick Sleep co-founded Nomad Investment Partnership and the fund returned 921.1% over 13 years versus 116.9% for the MSCI World Index. In other words, $1 million invested with the index would have grown to $2.17 million, while $1 million invested in Nomad would have rocketed to $10.21 million! They did this by concentrating the portfolio in three stocks—Amazon, Costco, and Berkshire Hathaway. Read on to find out his formula for generating alpha!
Scaled Economics Shared: The Perpetual Growth Machine
One of the most powerful concepts out there is scaled economics shared. As a company grows larger, it is able to spread its fixed costs (e.g., warehouse) over a larger base, gain economies of scale and increase its bargaining power over suppliers. Normally, this creates a lot of value for shareholders, at least in the short run, as profit margins expand with rising revenue.
However, high profit margins attract competition like bees to honey. Smaller companies who witness these high profit margins will attempt to break into the market to get a slice of the pie. Capitalism is brutal and competition will erode a company’s margins as it slows down revenue growth and reduces pricing power.
Scaled economics shared suggests that companies share their cost savings with the customers and customers would then reward the companies with more sales. This cycle is best illustrated with Jeff Bezos napkin sketch:
Increased revenue brings about cost savings and lowering prices with the cost savings attracts more customers, and brings in even more revenue. And the cycle continues. As time goes by, barriers to entry for competitors increase with size of the company and the moat of the company significantly widens as it shares the benefit of scale with the customer.
Usually as a company scales and matures, growth will start to slow down and things start to go downhill as they’re less nimble than their younger competitors who are attracted by the fat profit margins. Scaled economics shared turns size, which is normally an anchor to growth and returns, into an asset!
As Jeff Bezos shared, “I very frequently get the question: ‘What’s going to change in the next 10 years?’ And that is a very interesting question; it’s a very common one. I almost never get the question: ‘What’s not going to change in the next 10 years?’ And I submit to you that that second question is actually the more important of the two — because you can build a business strategy around the things that are stable in time. … In our retail business, we know that customers want low prices, and I know that’s going to be true 10 years from now.”
Passing benefits to customers in the form of low prices allows businesses to compound for as long as the moat continues to widen with scaled economics shared. Jim Sinegal, founder of Costco, understood this so much so that when his CEO Craig Jelinek told him that they needed to raise the price of Costco’s iconic $1.50 hot dog and soda combo, this was what Sinegal said:
Let’s backup to Amazon here for a second. In Sleep’s letters, he shared that ecommerce companies have a capital advantage over traditional brick and mortar businesses. The Achilles heel for internet companies are its operating costs, which are especially high as a proportion of revenue, especially at the early stages in a firm’s development. By adopting scaled economics shared, Amazon’s revenue quickly ramped up and operating costs as a proportion of revenue went down significantly—so much so that they became lower than some main high street chains, such as… wait for it… Walmart!
In other words, Amazon now has a capital cost and an operating cost advantage over their competitors.
Sleep goes on to point out that Amazon executed scaled economics shared so well that its operating costs (per dollar of sales) plus its operating margin are less than its competitors! This means that even if Amazon’s competitors were to price their products at just breakeven, it still wouldn’t affect Amazon’s prices or profitability.
We should take a pause to think about that—Amazon has the ability to completely price their competitors out of the market while being profitable—it is hard to find a business model with a greater margin of safety than this.
When it comes to compounding our wealth, the longevity of the compounding process is of utmost importance. Companies that practice scaled economics shared significantly increase their chances of compounding for many years to come.
Afterall, who doesn’t like low prices?
The Hidden Investment
Intricately tied to scaled economics shared, is the investment in price-giveback, by actively lowering prices, customers enjoy between 2% to 10% worth of savings at Amazon compared to shopping at other places, according to Sleep.
The amount of revenue “lost” from actively lowering prices can dwarf other items of investment spending such as R&D and sales & marketing, even though it is not captured anywhere in the financial statements. Sleep explained that investment in price-giveback is the most long-lived investment spending item if it creates a lasting consumer habit.
Here is what Jeff Bezos, Amazon founder has to say about price-giveback in their annual report:
The Aggregation of Marginal Gains
Little things can add up to make a big difference. Sleep prefers to invest in companies whose comparative advantage comes from doing many little things right rather than a company that relies on just one big advantage—brand name, location, clever reinsurance contract, or a patent.
Consider a one big advantage firm, such as a drug company. A successful drug company does not need to be good at marketing, manufacturing, or R&D if, through a patent, it has a legal monopoly on a drug.
But this advantage is fragile. A rival could displace it any time with better technology and there would be little to fall back on. The longevity of its profitability may be quite finite and detrimental to investors’ compounding process.
Compare this to a scaled economics business. In order to outmuscle a competitor’s cost base, a company has to be superior at a million little actions—a much tougher feat, but also making the company much tougher to displace.
Sleep shared, “Firms that have a process to do many things a little better than their rivals may be less risky than firms that do one thing right because their future success is more predictable. They are simply harder to beat. And if they are harder to beat then they may be very valuable businesses indeed.”
Portfolio Inactivity is an Active Decision
Not doing anything is, oddly, hard to do. Afterall, humans itch to be seen doing something, especially for fund managers who are paid a salary to be doing something. Also, passing over an investment after hours spent researching a business is tough, because it feels like effort down the drain.
Always measure new companies against your existing portfolio and only let them in if they are superior to what you already own.
The decision to not change the portfolio is an active decision.
Thoughts on Volatility
Resist the urge to sell your winners to buy losers, and vice versa. Investors have no control over the chronological sequence of good years and bad years and Sleep does not trade around their holdings.
Good investing is about destinations, not smooth routes. Share prices are more volatile than business values.Take the chart of Amazon by Sleep, share prices fluctuate all over the place despite steady growth in revenues.
Focus on lasting value, not transitory prices. Focus on the inputs to future value moves.
Information Diet
When Sir David Attenborough was praised on BBC for being the most widely travelled and one of the most knowledgeable naturalist, this was his reply, ““Well…I suppose so…but then on the other hand it is fairly salutary to remember that perhaps the greatest naturalist that ever lived and had more effect on our thinking than anybody, Charles Darwin, only spent four years travelling and the rest of the time thinking.”
In other words, Attenborough is suggesting that time spent thinking trumps endless data collection. With the internet and the liberalisation of data, investors may be lured into endless gathering of data that we hardly have time to think at all.
Sleep opines that we should de-emphasise data collection and think about the factors that make a business great.
Information, like food, has an expiry date. Sleep spends most time thinking about information that has the longest shelf life, with the highest weighting going to information that is almost axiomatic.
Super High Quality Thinkers
Sleep keeps a list of companies he calls “super high quality thinkers”, and the criterias set out are good for evaluating management:
Intellectually honest and economically rational
Chosen to out-think their competition and allocate capital over many years with discipline to reinforce their firm’s competitive advantage
Able to resist growing when returns on capital are poor
The ideal portfolio would comprise this list of wonderful, honestly run compounding machines, which Sleep refers to as the “terminal portfolio”. Prior to closing his fund and retirement, the fund mainly comprised three stocks: Amazon, Costco, and Berkshire Hathaway—all run by super high quality thinkers.
An Investor’s Edge
What is your competitive advantage in investing?
There are three competitive advantages in investing:
Informational – I know a meaningful fact nobody else does
Analytical – I have cut up the public information to arrive at a superior conclusion
Psychological – Behavioural
Of the three, only analytical and psychological competitive advantages are sustainable. Mr. Market is efficient, but not all the time. It is during these pockets of inefficiencies where our analytical and psychological capabilities are put to the test.
Conclusion
Nick Sleep seeks to break down drivers of business value into its simplest form and not rely on complex models. Like Munger, he applies multiple disciplines for mental models for his investment process which led him to discover insights that other investors couldn’t see. His letters are a gem and it is definitely worth reading and re-reading.