The Nomad Partnership Letters (Nick Sleep, Zak Zakaria)
“Take a simple idea and take it seriously.” — Charlie Munger
“The trick, it seems to us, if one is to be a successful long-term investor, is to recognize the sources of enduring business success, get in early and own enough to make a difference.
Which raises two questions: what are the sources of success and second, if these are so readily recognized up front why are they not discounted in prices already?” - Nick Sleep
My favorite chapter in William Green’s book Richer, Wiser, Happier is the story of Nicholas Sleep and his partner Qais ‘Zak’ Zakaria, two young analysts with strong opinions about the investment industry who started their own partnership, Nomad Investment Partners. Sleep had been an analyst at value shop Marathon Asset Management and met Zakaria, a misfit at Deutsche Bank, while digging through discounted stocks in the wake of the Asian financial crisis. The two partnered up (first under the Marathon umbrella) and, from 2001 to 2014, crushed the market.
Not only that: after reading their letters, I am convinced that they had an absolute blast investing together. They did what they loved: studying companies, talking to operators, reading broadly to accumulate worldly wisdom, and reflecting deeply on what they learned. They practiced their craft with a dedication to quality, curiosity, introspection, long-term focus, and ethical partnership with their investors.
Their journey took them from deep value (turnarounds, out of favor emerging markets, companies tainted by scandal) to Costco and its model of “scale efficiencies shared.” Armed with this idea, they did what Munger suggested: they took it seriously and considered all its implications. They searched for historic case studies, looked for more companies with the same model, and contemplated how the model affected the company’s risk profile and therefore size in the portfolio.
As William Green pointed out in his wonderful book, this commitment to purity of craft came at an expense: when Sleep and Zakaria asked their investors to let them increase the concentration limit, a quarter of them redeemed.
Today, we can read the letters for free here (kicked off by a letter from Warren Buffett who congratulated them on their decision to retire and spend their time on charitable projects.) I also posted my preliminary notes on Twitter.
I highly recommend the letters to any investor for three reasons: Sleep and Zakaria were astute and successful investors and provided helpful case studies and discussions of business models. Second, you can follow their journey through an entire market cycle and evaluate how early decisions panned out. Lastly, Sleep and Zakaria had some strong opinions about the investment management industry. I respect that they took a principled stand and designed the partnership to fit their unique approach, rather than optimizing for growth in assets under management and the needs of institutional allocators.
The letters are also compelling because Sleep drew on insights from a wide variety of disciplines. This reminded me of Bill Miller who I believe mentored the two. Sleep and Zakaria quoted Miller, attended his Legg Mason Investment Conference, used Dell as a case study (Miller was a big investor), and invested in Amazon (Miller was the biggest outside shareholder). They also joined the Santa Fe Institute where Miller served as Chairman. They even studied gamblers, just like Miller did.
In this piece I’m going to share some of my favorite quotes and learnings. If you don’t have the time to read 225 pages of letters, you can use this as a reference. All quotes are by Sleep and Zakaria and almost all are from the letters though a handful are from Richer, Wiser, Happier.
“Investing is, at its heart, a very simple discipline. Simple, perhaps, but not easy. And judging by my efforts, certainly hard to communicate. The truth is that there is not that much to say, at least, not much that hasn’t been said before.”
Table of Contents
Philosophy.
Intrinsic motivation.
Minimize distractions through simplification.
Long-term orientation.
Trust creates flexibility.
Focus.
Long shelf life insights.
Discussing stocks in public.
Case studies.
Costco leads to the big idea.
Thought exercises.
More case studies.
Inverting the question.
Mistakes.
Bezos.
Culture.
Misunderstood.
Anti-culture.
2008.
Deep realities.
Inactivity is a decision.
Incentives.
Analogies.
Closing quotes.
Philosophy.
Sleep studied geography in college, a subject "with an identity crisis" as he called it, in which he learned to draw from a wide variety of different disciplines: “geology, physics, chemistry, oceanography, climatology, biology and that is just physical geography. Human geography deals with sociology, psychology, statistics, economics – so it is the ultimate polymath course.”
Sleep also read Zen and the Art of Motorcycle Maintenance by Robert Pirsig, a book about pursuing quality, and noted “the two just combined to change how I viewed the world.” The pursuit of wisdom and quality permeated their work, their philosophy as investors, and how they built their own business.
“Worldly wisdom is a good phrase for the intellectual capital with which investment decisions are made and, at the end of the day, it is the source of any superior investment results we may enjoy.”
“Zak and I have come to appreciate the value in retreating a little from endless stock analysis. From time to time we swap slippers for brogues and head out into the world with the expectation that what we learn through investing helps us in other activities outside the office, and what we learn doing other activities helps us as investors.”
“You really want to do everything with quality as that is where the satisfaction and peace is.”
Intrinsic motivation.
“Zak and I don’t want to be busy; we want to be right.”
Sleep and Zakaria started their partnership because they loved the intellectual challenge and craft of investing and sought to minimize the business of investing.
They kept management fees low (it was a cost reimbursement that decreased over time as AUM increased), didn’t market, and closed the fund unless there was an opportunity to deploy more capital. They just wanted to solve investment puzzles.
“There are, perhaps, few things finer than the pleasure of finding out something new. Discovery is one of the joys of life and, in our opinion, is one of the real thrills of the investment process.”
“All Zak and I have done is catch some better waves and try to ride them to the shore. Riding waves is not an expensive activity and Nomad’s (cost reimbursement) management fee remains around ten basis points.”
“The very rapid rejection of things made life very straightforward. It was all about quality. Money was secondary. It was much more bout doing a good job, a quality job, doing the right thing.” Zak Zakaria
“It’s not the cake that gratifies us. What we found gratifying was the process of solving the investment problem, learning along the way and doing as good a job as we knew how—they are all internal personal goals. The cake was then a (happy) byproduct.”
The proof was not just their fee structured but also their early retirement when they felt they had “sucked dry” the intellectual challenge of investing.
“One of our favourite cartoons, carried by Punch in the 1970s (and reproduced in the book “Influence: The Psychology of Persuasion” by Robert Cialdini some years later).”
Minimize distractions through simplification.
Their style of investing was to gather a lot of information, explore the world, talk to people – and think deeply about it. It was best served by an environment with a minimum of noise and inbound distraction.
“Zak and I consider noninvestment distractions to be the single biggest risk to our operation and we are on to it.”
“We just read annual reports until we were blue in the face and visited every company we possibly could until we were sick of it.”
"Zak and I run a single partnership that has long-term investments in the shares of, for all that matters, ten companies, all paid for with cash. We own the investment advisor that manages the partnership and, ordinarily, we are closed to incremental subscriptions and so free of marketing obligations. That’s it.”
Long-term orientation.
Sleep consistently derided the investment industry’s focus on short-term results and portfolio turnover. His obsession was to create an ecosystem of long-term thinking among themselves, their investors, and the companies they invested in.
“It’s all about deferred gratification,” says Sleep. “When you look at all the mistakes you make in life, private and professional, it’s almost always because you reached for some short-term fix or some short-term high.… And that’s the overwhelming habit of people in the stock market.”
“One of Nomad’s key advantages will be the aggregate patience of its investor base. We are genuinely investing for the long term (few are!), in modestly valued firms run by management teams who may be making decisions the fruits of which may not be apparent for several years to come.”
“If Nomad is to have a competitive advantage over our peers this will come from the capital allocation skills of your manager (if any) and the patience of our investor base. Only by looking further out than the short-term crowd can we expect to beat them. It is for this reason we named Nomad an Investment Partnership and not a fund. The relationship we seek is quite different.”
“Miller argued that 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) and psychological (that is to say, behavioural). Sustainable competitive advantages are usually a product of analytical and or psychological factors, and the overwhelming advantage with regard to Nomad is the patience of the investor base and the alignment of that disposition with the analytical and psychological traits of your manager.”
Trust creates flexibility.
“Your trust allows us to make mistakes (Conseco, Fleetwood Enterprises – please don’t point out they are from the same industry!) and change our mind quickly and without fear of rebuke (MBIA); invest in brilliant businesses (Amazon, Berkshire Hathaway, Costco et al) and so-so businesses (Stagecoach Group, Holcim Philippines, USG); invest with great concentration (Stagecoach, Amazon, Michael Page) and in baskets of several small holdings (four companies in Zimbabwe).”
Focus.
Sleep and Zakaria had the flexibility to invest all over the world but ended up with a focused portfolio. Filtering information and deciding where to focus was a key skill.
“The prime determinants of outcome are price (sticking to 50 cents on the dollar) and capital allocation by management. The first is in our control, that is, it is in our control to be patient and wait for the right price. The second involves a subjective judgment about the quality of management, and an assessment about the sustainability of business returns in the long run. It is these factors that occupy almost all our time.”
“One trick that Zak and I use when sieving the data that passes over our desks is to ask the question: does any of this make a meaningful difference to the relationship our businesses have with their customers? This bond (or not!) between customers and companies is one of the most important factors in determining long-term business success.”
Long shelf life insights.
Sleep compared information with food, comparing “fact content” and “fat content” long before the fake news debate.
“Information, like food, has a sell by date, after all, next quarter’s earnings are worthless after next quarter. And it is for this reason that the information that Zak and I weigh most heavily in thinking about a firm is that which has the longest shelf life, with the highest weighting going to information that is almost axiomatic: it is, in our opinion, the most valuable information.”
Discussing stocks in public.
As Nomad became more successful (and as its letters were being shared more widely), Sleep and Zakaria debated the dangers of discussing individual stocks – and increasingly refrained from it.
“The problems are mainly psychological and include the locking in of an idea, the desire to seem consistent, the wish to seem prudent in other people’s eyes and so forth.”
“Fund managers should have absolute conviction on the philosophy and methodology of their investment principles, providing of course that those principles reflect reality But they should be circumspect about expressing these tenets as they relate to individual stocks. Evangelism is not healthy. The reason is that, whilst fund managers have it in their powers to control the way they think, they are unable to control how their companies behave.”
Case studies.
Most investment write-ups were communicated in separate investment updates which are not available online. However, the letters include several case studies and discussions of wins and mistakes. You can jump into the letters and use the search function to read up on the following: Stagecoach (traditional turnaround), Xerox (investment after accounting scandal), Zimbabwe (basket of stocks in a basket case economy), Weetabix, emerging markets (“Speech at TIFF”, Union Cement), MBIA (a financial crisis mistake), and of course Costco, Amazon, and Carpetright (examples of scale economies shared).
Costco leads to the big idea.
The couple started investing in traditional value before they found one big idea that, over time, came to dominate the portfolio.
“When we evaluate potential investments, we are looking for businesses trading at around half of their real business value, companies run by owner-oriented management and employing capital allocation strategies consistent with long term shareholder wealth creation.”
“Today, the opportunities are mainly small and mid-capitalization companies, especially in Asia, and mainly turnarounds in nature (which bring with them reinvestment risk once the stock is sold).”
When they found Costco in 2002, the market was doubting its business model and shares were on sale. Sleep and Zakaria saw the benefits of Costco’s every-day-low-pricing model (a fixed markup that keeps margins low on all items and passes cost savings from on to customers) but it took some time before they appreciated the greater implications of scale efficiencies shared:
“This is a very simple and honest consumer proposition in the sense that the membership fee buys the customer's loyalty (and is almost all profit) and Costco in exchange sells goods whilst just covering operating costs.”
“By sticking to a standard mark-up savings achieved through purchasing or scale are returned to the customer in the form of lower prices, which in turn encourages growth and extends scale advantages. This is retail’s version of perpetual motion and has been widely employed by Wal-Mart among others.”
“Costco management describe the strategy as “easy to understand and hard to operate" perhaps because the temptation is to mark up the goods and break the contract with the customer.”
“Costco is as perfect a growth stock as we have analysed and is available in the stock market at a close to half price.”
Thought exercises.
Sleep and Zakaria spent time thinking deeply about business models and created a wish list of great companies and great managers.
“In the office we have a white board on which we have listed the (very few) investment models that work and that we can understand. Costco is the best example we can find of one of them: scale efficiencies shared.
The anointed few are there because they have chosen to out-think their competition and allocate capital over many years with discipline to reinforce their firm’s competitive advantage. Good capital allocation takes many forms and does not necessarily require a firm to grow.
This list is a group of wonderful, honestly run compounding machines. We call this the ‘terminal portfolio.’”
They now recognized that there was something truly special about Costco’s model
“In the center of the model is a paradox: the company grows through giving more back. We often ask companies what they would do with windfall profits, and most spend it on something or other, or return the cash to shareholders. Almost no one replies give it back to customers – how would that go down with Wall Street? That is why competing with Costco is so hard to do. The firm is not interested in today’s static assessment of performance. It is managing the business as if to raise the probability of longterm success.”
Greater scale led to more cost efficiencies and unlocked further growth.
Another interesting thought exercise (I recommend to look this one up in the letter and read the entire section): “What characteristics could one bestow on a company that would make it the most valuable in the world? What would it look like?”
“Such a firm would have a huge marketplace (offering size), high barriers to entry (offering longevity) and very low levels of capital employed (offering free cash flow).”
Costco had some of these attributes. But it was not perfect (it required significant investment into new stores and inventory, for example). Instead, they considered eBay as a possible contender for the “perfect company.”
More case studies.
Sleep and Zakaria realized that successful outlier companies had used this model in the past and built an arsenal of case studies. This included GEICO, Southwestern Airlines, Walmart, Dell, and others. All were competing in large and relatively commoditized or markets, insurance, retail, aviation.
“While reading the 2005 Berkshire Hathaway Annual Report, one paragraph stood out for us as Warren Buffett referred in passing to the division of operating and underwriting cost savings at motor insurer GEICO. These “benefits” were divided between shareholders, policy holders and employees and the statistics spelt out in some detail.”
They even traced it back to Henry Ford.
“For example, it is interesting to note that the business model that built the Ford empire a hundred years ago and is illustrated in the chart below (dated 1927), is the same that built Sam Walton’s (Wal-Mart) in the 1970s, Herb Kelleher’s (Southwest Airlines) in the 1990s or Jeff Bezos’s (Amazon.com) today. And it will build empires in the future too. The longevity of the model is not difficult to understand as Jeff Bezos pointed out “I can’t imagine that in ten years from now customers are going to say: I really love Amazon, but I wish their prices were a little higher” or Amazon was less convenient, or they had less selection.”
Chart 1: Production Volumes and Cost (to the consumer) of Ford Cars 1908 to 1924.
“Source: The original 1927 report of the Franklin Institute of the State of Pennsylvania for the Promotion of the Mechanical Arts, recommending “Mr. Henry Ford, of Detroit, Michigan” for the Institute’s Elliott Cresson Medal. Line A illustrates the volumes of cars produced, in this case from zero to just over two million per annum. Line B describes the decline in cost (probably to the consumer) of the Model T Ford from U$950 to around U$300. The x-axis refers to the calendar years 1908 to 1924.”
Chart 1: Production Volumes and Cost (to the consumer) of Ford Cars 1908 to 1924.
“Source: The original 1927 report of the Franklin Institute of the State of Pennsylvania for the Promotion of the Mechanical Arts, recommending “Mr. Henry Ford, of Detroit, Michigan” for the Institute’s Elliott Cresson Medal. Line A illustrates the volumes of cars produced, in this case from zero to just over two million per annum. Line B describes the decline in cost (probably to the consumer) of the Model T Ford from U$950 to around U$300. The x-axis refers to the calendar years 1908 to 1924.”
Inverting the question.
As they evolved their strategy to focus on holding great companies for the long-term, they inverted the key questions of how to identify and hold on to these companies. First, they asked: "What is it about growth stocks that dooms them to failure?"
“The answer is that success encourages competition, and capital flows into an industry to compete away the excess returns. Like all heuristics, this works most of the time, and we can all think of businesses that were super profitable for a while before the competition caught on. But what of those that don’t fail? Michael Dell succeeded by keeping costs low and passing back his scale benefits to the buyer of his PCs. By the time the competition had matched him in pricing he had moved on. And on and on. Amazon.com may be following this path as well. So, the first point is that whilst Costco continues to recycle cost savings to the consumer, it is lowering the probability of failure.”
“If Dell is the appropriate model for Costco, then the probability of failure is lower than for most growth stocks. It is lower again when one considers self-funded, as opposed to, rented growth. And lower again when one considers the fixity of mark up. To a far greater extent than for many businesses the company controls its own destiny. So, what attracted us to Costco is the predictability of outcome: we don’t think it is going to fail for many years.”
This belief that the business model of an expanding moat at greater scale lowered the risk led them to become more concentrated in stocks like Costco and Amazon.
“There are very few business models where growth begets growth. Scale economics turns size into an asset.”
The second question was “what makes investors sell prematurely?” They came across the story of a Baltimore-based asset manager (I’ve heard this was T. Rowe Price) who made this mistake twice:
“In the early 1970s a then, and still today, large successful fund management company analysed its portfolio and discovered that their sale of IBM thirty years earlier had been a huge error of omission at about the same time, they also made the decision to sell their stake in Wal-Mart.”
“The market struggled to appreciate the magnitude and longevity of the business’ success. But why?”
(This is another section that is worth reading in its entirety in the letters, in this case June 2009, page 156)
“Misanalysis, or using the wrong mental model: Investors are used to firms which have one good idea, such as a new product, but then struggle to replicate success and end up diluting return.”
“Structural or behavioral: Active fund managers have to look active.”
“Odds or incorrectly weighing the bet: In the words of my first boss, investors tend not to believe in “longevity of compound”. Conventional thinking has it that good things do not last, and indeed, on average that’s right!”
“No doubt some combination of these, plus others, acted in the minds of sellers. It matters not particularly. What matters is the effect of this collective mis-cognition. Investors know that in time average companies fail, and so stocks are discounted for that risk. However, this discount is applied to all stocks even those that, in the end, do not fail. The shares of great companies can therefore be cheap, in some cases, for decades.”
In other words, they believed scale efficiencies shared was a business model that led to greater than expected longevity. This was a quality that underappreciated (and undervalued) by short-term oriented investors.
“It could be argued that lots of things had to go right for Wal-Mart to grow for forty years. That is certainly true but, at its heart, a very few simple things really mattered the central engine of success at Wal- Mart was a thrift orientation fueling growth with the savings shared with the customer. This is the deep reality of the business. This should have had the greatest weighting in the minds of longterm investors even if other things looked more important at the time.”
“The removal of a portion of failure risk from the investment equation creates a huge opportunity for those investors that can see the company in its true perspective and act with a bit of patience.”
Mistakes.
“What you are trying to do as an investor is exploit the fact that fewer things will happen than can happen. So, you are trying to figure out how that probability distribution works and stay in the middle of what will happen. The market has to worry about all the things that can happen.” Bill Miller, quoted in the Nomad letters
While Sleep discussed specific mistakes (like Conseco and MBIA), his focus was on the difference between mistakes of commission and omission. Conseco had been a painful loss. But selling companies like Stagecoach too early had cost the fund more.
“The biggest mistake an investor can make is to sell a stock that goes on to rise tenfold, not from owning something into bankruptcy. But that’s what everyone thinks, at least judging by the questions we get from clients. Only last week we got questions about our holding in Northwest Airlines rather than the sale of Apple earlier this year. But selling Apple has cost us more. People look at actual costs, not opportunity costs. And what did we say about over-weighing the vivid evidence? And if you understand that, and you understand probabilities, then you’ll know Northwest wasn’t worth calling us about.”
“We have argued that the biggest error an investor can make is the sale of a Wal-Mart 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. … Our greatest error was the sale of Stagecoach (which has risen ever since sold), not the purchase of Conseco!”
“The analytical mistake in both cases was to have a static view of a firm formed at the time of purchase, which failed to evolve as the facts changed. This error was reinforced by misjudgments such as denial (the facts had changed) and ego (we can’t be wrong).”
“In allowing past habits to anchor portfolio construction we have probably made the mistake of a starting holding that was almost certainly too low.”
“There was also an over-reliance on price to value ratio type analysis, which can encourage a tighter range of outcomes than occurs in reality.”
Bezos.
While they invested in a number of companies that pursued scale efficiencies shared, Amazon became the prime holding (some pun intended). And this was before considering whether AWS was another example of this business model (a subject for another time).
“Jeff Bezos, Amazon’s founder, had to say in last year’s annual report: “As our shareholders know, we have made a decision to continuously and significantly lower prices for customers year after year as our efficiency and scale make it possible.”
“This is a précis of the scale efficiencies shared model that we dealt with in some detail in our analysis of Costco and is deployed by companies which have now come to dominate Nomad: Costco, Dell, Amazon and Berkshire (Geico, Nebraska Furniture Mart.”
“Jeff Bezos, founder of Amazon, made the following point in a recent interview in Wired magazine:
“There are two ways to build a successful company. One is to work very, very hard to convince customers to pay high margins [the Colgate, Nike, Coca-Cola model alluded to above]. The other is to work very, very hard to be able to offer customers low margins [the Wal-Mart, Costco, AirAsia, Amazon, Asos model]. They both work. We’re firmly in the second camp. It’s difficult – you have to eliminate defects and be very efficient. But it’s also a point of view. We’d rather have a very large customer base and low margins than a small customer base and higher margins.”
“Although Mr. Bezos does not mention it, one reason he prefers Amazon to be a large company with small margins is that if he shares the efficiency benefits that come with growth with his customers, he turns size, frequently an anchor on business performance, into an asset.”
William Green wrote that the decision to make Amazon a 20 per cent position, which required approval by their investors, cost Sleep and Zakaria a quarter of their AUM. Though the letters suggest that other investors were eager to join.
Culture.
They increasingly focused on company culture and realized that some of their favorite companies succeeded due to an “aggregation of marginal gains,” creating “an interlocking, self-reinforcing network of small actions.” There was no one thing that explained success. Sleep called the search for this “smoking gun” a framing error, “the brain tends to latch on to what can be easily found to “frame” the situation, and if what is easily found is also vivid, then the brain stops looking for another explanation.” But the explanation was cultural.
“Cultures that care about the little things all the time are very hard to create and, in the opinion of Amazon.com founder Jeff Bezos, almost impossible to create if not put in place at the firm’s genesis.”
“No, no, Nick, there is no secret sauce here”, one senior executive explained, “we don’t do one thing brilliantly, we do many, many things slightly better than others”.
“The uniqueness of Nomad’s ecosystem is the look-through consistency of approach of its participants, from Mr. Bezos and the good folks that run Nomad’s other businesses, to Zak and me and on to our investing partners. We are all choosing to see the world in the same way.”
“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.”
“The opportunity for Nomad’s investors comes from realising to whom these firms are more valuable. Certainly not the short-term investor, who will be indifferent as to whether Amazon, Asos or Air Asia will be the most valuable retailer/fashion e-tailer/airline in the world in ten years’ time.”
“Early years of Rolls-Royce Limited, the manufacturer of motor cars, where Frederick “Henry” Royce made the engineers personally sign the parts they were responsible for making. That way, if any component proved faulty, he knew who was responsible and he made them correct the fault in their own, unpaid time – I paid you to make a working part, not a faulty part, he would argue.”
Costco’s culture, for example, was deeply ingrained.
“When Zak and I met Jim Sinegal, Costco’s CEO, Jim suddenly stopped in mid-sentence, his face lit up, “I must show you this” he said and disappeared into a filling cabinet. He emerged with a memo from 1967 written by Sol Price, Fed-Mart’s founder (the predecessor firm to Costco), “here you can have a copy of this” he said, and that copy is framed on our office wall. The memo says this:
“Although we are all interested in margin, it must never be done at the expense of our philosophy. Margin must be obtained by better buying, emphasis on selling the kind of goods we want to sell, operating efficiencies, lower markdowns, greater turnover, etc. Increasing the retail prices and justifying it on the basis that we are still “competitive” could lead to a rude awakening as it has with so many. Let us concentrate on how cheap we can bring things to the people, rather than how much the traffic will bear, and when the race is over Fed-Mart will be there”. [The best summary of the business case for scale economics shared we have come across].”
Misunderstood.
“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 (AirAsia); 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?”
Anti-culture.
If there was a positive culture, there was also a culture to avoid. One with the wrong focus and incentives.
“What Charlie Munger called the “locker room culture”. This is an attitude whereby the players just have to win, and they are not too squeamish about the means.
If the shareholder base of a listed firm is dominated by, say, mutual funds that, in turn, are seeking short term performance, then that too will be what they will seek in their investments Both parties will care for short term outputs and will take from the long-term to meet their needs.
Upton Sinclair, “it is difficult to get a man to understand something when his salary (or bonus) depends on his not understanding it”.
“Our anti-locker room disposition was echoed by the founder of one of Nomad’s investee firms, who, in a private meeting, put it as follows: “if you want to be successful, and we do, then you have to be willing to be misunderstood, and do things that do not seem sensible to most people”. For example, “if you (employees) come into the office in the morning thinking how you are going to beat number one, two or three in the industry” - how many times have we heard companies articulate that view? - “then, our firm is the wrong place for you. We start with the customer and work backwards.”
2008.
The partnership was battered with a decline of some 45 per cent in 2008. However, you will not find a hint of panic in the letters. On the contrary, being invested in strong companies led by owner operators (or managers with an owner’s mindset), Sleep and Zakaria felt that this was a seminal moment. Their companies were going to emerge stronger than competitors. They also bought some cigar butt investments though it seems they later regretted that decision.
“It may not feel like it but, in many respects, these are the best of times for an investor, and we shall lay out why in this letter.” (December 2008)
“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.” (June 2008)
“If we had our time again, we would hope not to be seduced by their (apparent) mathematical cheapness but weigh more heavily their DNA, if you like. One of the things we have learnt over the last few years is that our most profitable insights have come from recognizing the deep reality of some businesses, not from being more contrarian than everyone else.” (December 2010)
“The largest group making up over half the Partnership are, no drum roll required, scale-economics-shared; next comes discounts-to-replacement- cost-with-pricing-power (I warned you) at around fifteen percent; hated-agencies fifteen percent; super-high-quality-thinkers just under ten percent.” (June 2009)
“In contrast to business behavior at large and the intimidating cyclical setting, many of our firms invested heavily.
Michael Page has kept sub-economic offices open whilst rivals have closed theirs, in an attempt to take permanent market share during the recovery; Costco Wholesale has used the decline in real estate values to increase the rate of site purchases for new stores; at Berkshire Hathaway, Warren Buffett has famously placed his “all in wager” on a recovery in the US economy.
There are two reasons that our firms have zigged whilst businesses as a whole have zagged. First, Nomad’s firms, by and large, have advantages not enjoyed by the incumbent competition and so have not been subject to the same economic imperatives. Second, their cultures are focused on the customer experience, not on the competition or the profit and loss statement. Our firms tend to chase the vision, not the money.” (December 2010)
Deep realities.
There was that word again, “our most profitable insights have come from recognizing the deep reality of some businesses.” Earlier, I quoted Sleep on Wal-Mart’s deep reality and its “central engine of success,” namely “savings shared with the customer.”
I believe Sleep and Zakaria retired when they had mastered this deep reality for one highly successful business model. It is unfortunate for us that they didn’t continue to analyze other companies, business models, and industries on their hunt for this kind of insight.
"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.
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). 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.”
Inactivity is a decision.
“The research continues but, as far as purchase or sale transactions in Nomad are concerned, we are inactive. Inactive except, perhaps, for the observation, seldom made, that the decision not to do something is still an active decision; it is just that the accountants don’t capture it.
“The investor Seth Klarman was once challenged on whether Buffett’s track record was statistically significant as he traded so little? To which Klarman answered that each day Buffett chose not to do anything was a decision taken too.”
Incentives.
“The incentives around high low retailing as compared to scale economics shared retailing. The incentives here are awful: customers are trained to buy on deal, be disloyal and shop around, and for the retailer the inefficiencies of pricing and repricing and the volatility of volumes are meaningful. Scale economics shared incentivises customer reciprocation, and customer reciprocation is a super-factor in business performance.”
“Zak and I sat down about ten years ago, over a sundown glass of Chardonnay at a bar in a Californian hotel and penciled the Nomad fee arrangements on a spare sheet of paper. It did not take long. We concentrated on the correct philosophical approach to incentives, and so the job was easy: the management fee should not be a profit centre.”
“And whilst conventional wisdom has, in our view, quite correctly drawn a Pavlovian link between financial incentives and behaviour, money is not the only reason that people behave the way they do. Those tasked with setting compensation arrangements may first wish to ask themselves, why do people climb mountains?”
“When we asked Nick Robertson, the founder of Asos, whose paper net worth has increased hugely since we have known him, whether, now he is a rich man, he has thoughts of leaving, his face lights up with the future possibilities of his firm and says he is having more fun now than ever before.
The same is probably true for Jim Sinegal before his retirement (Costco), Lord Harris (Carpetright) and some of the other founders of the firms in which Nomad has invested. These people derive meaning from the challenge, identity, creativity, ethos (this list is not exhaustive) of their work, and not from the incentive packages.”
I will close out with an example of Sleep drawing on insights from other disciplines and some final quotes I enjoyed. I hope you learned as much from the Nomad letters as I did!
Analogies.
“What can Investors learn from Scaling Laws? A business ought to be able to self-fund its own growth, and if the opportunity set is large, then the return on capital needs to be suitably high. Second, barriers to entry should increase with size; that way a company’s moat is widened as the firm grows. To do this, the basic building block of the business, its skeletal structure, is probably best kept very simple. In short, we want a skeletal structure that can support growth from mouse to elephant without too much skeletal reengineering.”
“It seems to us that the basic building block of internet retailing, its skeletal structure, is far more robust, scalable and cheaper than the high street equivalent. In other words, its power law is very high, and implies that businesses with the simplicity of operation as say, Amazon.com, have a shot at being far bigger, quicker and more profitable than their high street equivalents.”
Closing quotes.
“One must see an investment not as a static balance sheet but as an evolving, compounding machine.”
“Truths are often spoken with a whispered voice whilst shaky suppositions are shouted for all to hear.”
“At its heart, investing is simple, and to make it seem anything but, with the frequent repartition of short-lived facts and data points, may be a conceit.”
“The performance that you receive, as partners in Nomad, is the capitalisation of the success of the firms in which we have invested (minus our fees!). To be precise, the wealth you receive as partners came from the relationship our companies’ employees (using the company as a conduit) have with their customers.”
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I have read the Nomad letters before. But your summarized version was a refresher of sorts. And timely refreshers like these are key to cementing certain principles in one's own toolkit for business analysis or leading a good life. Thanks for this...
This was really great. I liked the point on fund managers having conviction on philosophy and methodology of their investment principles