True investment success is rare, and even more so is the prospect of long term success; an investor’s returns that outperform the index year on year. Rarer still is the prospect of gaining insights into how the most successful in the investing world have achieved that success. And let’s be honest; we’re all looking for information that will give us an edge; those pearls of wisdom that allow us to intimately understand the thoughts and mental models of the great investors. But this information is sometimes so hard to find, it’s almost like searching for the Dead Sea Scrolls - We know it exists but we’re not quite sure where to look.
If the Dead Sea Scrolls had an investing equivalent, Nick Sleep’s letters would be it. For a long time these letters have been as rare as hen’s teeth, and because of this, and the gems contained within, they have been coveted by investors the world over. Only in the last few months have they surfaced publicly. Having spent the better part of the last few decades studying the world’s best investors, businesses and CEO’s, I’ve read hundreds of letters, interviews and books. And what I have found is that Mr Sleep’s remarkable insights and creativity in investing are almost without peer.
In 2001, after a decade in the industry, Sleep and his partner Qais Zakaria launched the Nomad Investment Partnership under the tutelage of Jeremy Hosking at Marathon Asset Management. The fund was spun out in 2006. After trouncing the index for thirteen years [20.8%pa vs index 6.5%pa], Nomad was closed in 2014 as Sleep & Zakaria sought more ‘caring pursuits’.
Like many of the world’s great investors, Nick Sleep came to investing from unorthodox beginnings. He didn’t study business or finance, but geography, a multi-disciplinary subject that nurtured a love of asking questions.
“Geography is a subject with an identity crisis – it is the confluence of 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. Geography just reached in to other subjects and grabbed what it thought it had to have. Indeed, the reason I studied Geography at all was because of this polymathic quality.”
“But because Geography is so broad, it claims little territory of its own.. Because Geography is seen as an academic gate-crasher, practitioners have had to ask themselves questions that other more homogenous subjects such as physics or chemistry have not.”
And it was Geography combined with Robert Pirsig’s seminal book, one occasionally referenced by the great investors, that reshaped his perspective on the world.
“I was reading ‘Zen and the Art of Motorcycle Maintenance’ by Robert Pirsig at the time, and the two just combined to change how I viewed the world. So I have this tendency to return to the basic questions.”
Mirroring the journey of many of the Investment Masters, Nick Sleep evolved as an investor. In Nomad’s early years the fund had almost half its assets in typical ‘value’ plays - discounted asset based businesses and deep value workouts - the ‘cigar butts’ that characterise Benjamin Graham’s investing style. Notwithstanding, Sleep could see that Nomad’s destination was in owning ‘honestly run compounding machines’. Nomad’s 2004 letter set out ‘the likely evolution of Partnership Investments’ which he referred to as the ‘terminal portfolio’ - where he wanted to go. By the time the partnership wound down the fund was characterised by a portfolio of these compounding machines; businesses deploying ‘scale-economic-shared’ models largely run by their founders.
Charlie Munger has often said ‘take a simple idea and take it seriously’. Sleep embraced this philosophy, grasping the market’s perennial undervaluation of ‘scale-economics-shared’ businesses. He formulated creative investment theses that he fortified through the mental models he collected from disparate disciplines; many not ordinarily applied to investing. When combined with a deep understanding of psychology, the application of relentless patience and a steadfast focus on each company’s destination, Nomad achieved an astonishing track record of performance.
There are so many lessons to draw from this incredible collection of investment letters it’s almost difficult to know where to begin. Sleep’s prescient views on Amazon are laid out in a roadmap in the early letters. A contrarian view on Costco from Nomad’s formative years is now conventional wisdom. I’ve included some of my favourite learnings below.
Think Long Term
“We own the only permanent capital in a company’s capital structure – everything else in the company, management, assets, board, employees can change but our equity can still be there! Institutional investors have never really reconciled their ability to trade daily with the permanence of equity.”
“There is a lot to be said for gentle contemplation. And of course, a long investment holding period allows one time between decisions to ‘retreat and simmer a little.”
“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.”
Focus on the Destination
“Destination analysis is consciously central to how we analyse businesses these days. It helps us ask better questions and get to a firm’s DNA.”
"The only real, long term risk, is the risk of mis-analysing a company's destination."
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!”
“We estimate that around three quarters of the portfolio is invested in growth businesses, which have the potential to compound for many years, and the balance in more cigar butt like investments (we just could not help it!).”
“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.”
Ignore the Noise
“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. Indeed, it could be argued that a running commentary obfuscates a discussion of the things that really matter.”
“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 the information 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.”
“The investment industry, as well as many economic commentators, spend so much time shouting. So much commentary espouses certainty on a multitude of issues, and so little of what is said is, at least in our opinion, knowable. The absolute certainty in the voice of the proponent so often seeks to mask the weakness of the argument. If I spot this, I metaphorically tune out. In our opinion, just a few big things in life are knowable. And it is because just a few things are knowable that Nomad has just a few investments.”
Psychological Advantages
“Charlie Munger’s ‘Psychology of Human Misjudgment’ speech given at the Harvard Law School in the mid 1990’s is the finest investment speech ever given. Not that he talked directly about investments. And that tells you something. But the most enduring advantages are psychological. And the trick here is to first understand them. And then train yourself out of them!”
Focus on the Business
“We own shares for multi-year periods and so our continued investment success has far more to do with the economics of the underlying businesses than it has to do with their last share price quote.”
"The trick, it seems to us, if one is to be a successful long-term investor, is to recognise the sources of enduring business success, get in early and own enough to make a difference."
“We can all observe that stock prices, set in an auction market, are more volatile than business values. Several studies and casual observation reveal that individual prices oscillate widely around a central price year in year out, and for no apparent reason. Certainly, business values don’t do this. Over time, this offers the prospect that any business, indeed all businesses, will be meaningfully mis-priced.”
Customer Relationships
“[Nomad’s firms’] 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.”
"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. It is this relationship that is the source of aggregate wealth created in capitalism."
“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. Recognising this can be very helpful to the long-term investor.”
Business Models
“Zak and I observe several business models that work in the long run, and scale economics shared is one of these... that is why companies that share scale with the customer make up around sixty percent of the portfolio.”
“The basic business models that lead to success don’t change that much and there aren’t that many of them.”
“We have little more than a handful of distinct investment models, which overlap to some extent.”
Management
“Our job is to pass custody of your investment over at the right price and to the right people.”
Founders & Management
“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.”
“Nomad’s investments may be in publicly listed firms but these firms are also overwhelmingly run by proprietors who think and behave as if they ran private firms.”
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.”
Risks of Pricing Power
“Early in a firm’s development it makes sense to reward customers disproportionately as customer referrals and repeat business are so essential to the development of a valuable franchise. With maturity this bias can be reduced and shareholders can reasonably take a greater slice of the pie. Too much, however, and the moat is drained with negative consequences for longevity. The temptations are enormous because capital markets will reward profiteering. There are many examples of companies which ‘harvest’ excessively, when perhaps they should focus on longevity. This may have been what happened at Coca Cola which has leant excessively on bottlers, or Gillette where advertising has been cut, or even at Home Depot which has boosted gross margin in recent years. Shareholders often suffer a double whammy as highly rated companies enter ‘growth purgatory’, because growth slows just at the time when shareholders spot the mis-analysis of reported profitability.”
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.”
Lollapalooza Moat
“There is not a prior reason why a comparative advantage should be one big thing, any more than many smaller things. Indeed an interlocking, self-reinforcing network of small actions may be more successful than one big thing… 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 [e.g. develop/own a patent] because their future success is more predictable. They are simply harder to beat. And if they’re harder to beat then they may be very valuable businesses indeed.”
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.”
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.”
Inaction - SOYA
“One common psychological trap that agents may fall into is that clients expect action, or to be more accurate, fund managers expect their clients to expect action! 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, too. It is quite possible that we may not change the companies we have invested very much over the next few years.”
“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 decision not to do something is still an active decision; it is just that the accountants don’t capture it. We have broadly, the businesses we want in Nomad and see little advantage to fiddling.”
“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!”
“Our portfolio inaction continues and we are delighted to report that purchase and sale transactions have all but ground to a halt. Our expectation is that this is a considerable source of value add!”
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.”
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."
Position Sizing
“It is common-place for overall portfolio construction to be as a result of stock weighting built up from one to two to three percent of a portfolio and so on up to a target holding. This means that weightings are anchored at a small number with only outliers reaching double digits. There is another way to construct a portfolio, which is to invert and start at a hundred percent and work down! If fund managers did this, I am sure they would end up with completely different portfolios. Now we are not advocating all the fund in Amazon (well, not just yet at least), but in allowing past habits to anchor portfolio construction we have probably made the mistake of a starting holding that was almost certainly too low.”
Diversification
“The church of diversification, in whose pews the professional fund management industry sits, proposes many holdings. They do this not because managers have so many insights, but so few! Diversity, in this context, is seen as insurance against any one idea being wrong. Like Darwin, we find ourselves disagreeing with the theocracy. We would propose that if knowledge is a source of value added, and few things can be known for sure, then it logically follows that owning more stocks, does not lower risk but raises it!”
“In our opinion, just a few big things in life are knowable. And it is because just a few things are knowable that Nomad has just a few investments.”
“Sam Walton did not make his money through diversifying his holdings. Nor did Gates, Carnegie, McMurtry, Rockefeller, Slim, Li Ka-shing or Buffett. Great businesses are not built that way. Indeed the portfolios of these men were, more or less, one hundred percent in one company and they did not consider it risky! Suggest that to your average fund manager.”
Learning
“We still have much to learn.”
“As a young(ish) man there is something slightly depressing about thinking things through for a while, arriving at a somewhat reasoned conclusion only to find that others have been there before, and years earlier. In some respects we are fifty years behind Buffett, but that’s ok, so long as the average investor is at least fifty-one years behind!”
“Discovery is one of the joys of life, and in our opinion, is one of the real thrills of the investment process; the cumulative learning that leads to what Berkshire Hathaway Vice-Chairman Charlie Munger calls ‘Worldy Wisdom’. 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.”
Patience
“At the beginning of the AGM of the Berkshire Hathaway Company they show this little video and each year Buffett is asked what’s the main difference between himself and the average investor, and he answers patience. And there is so little of it these days. Has anyone heard of getting rich slowly?”
“Good investing is a minority sport, which means that in order to earn returns better than everyone else we need to be doing things different to the crowd. And one of the things the crowd is not, is patient.”
Summary
These observations are but a fraction of the insights espoused in Nomad’s letters. Discourses on investment edges, the ‘robustness ratio’, business models, ‘value vs growth’, the ‘equity yield curve’, fee structures and behavioural finance more generally, while not included here, are worthy of their own posts. Sleep’s observations on habit change and the implications for internet retailing are imminently relevant in light of today’s Covid-19 inflicted consumer landscape.
Nick Sleep didn’t rely on complex models, non-public information or business relationships to deliver his returns. Like Munger, he reached into other disciplines for mental models he could apply to his thinking. Asking questions, thinking things through, turning ideas upside down and challenging conventional wisdom led to insights other investors couldn’t see. Sticking within his core competency, keeping it simple, and recognising the basic nature of the businesses he owned accorded him the patience to remain invested in compounding machines. Despite Nomad’s closure, Sleep remains invested in Amazon and Costco to this day.
Like Buffett’s missives, Nomad’s wonderfully articulate letters are likely to prove a rewarding resource that can enhance investment success. I implore you to read them. And then, re-read them. These are an absolute rarity that have recently come into the public domain, and offer as much relevant wisdom in today’s landscape as they did when they were first written. The Dead Sea Scrolls, indeed.
Further Reading:
The NOMAD Investment Partnership Letters - 2001-2013 are available on Mr. Sleep’s charitable foundation website here .. I.G.Y Foundation
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