Nick Sleep Letters - Seneca of the Wall Street !
The Nomad Investment Partnership was
launched in early September 2001 and began investing on September 10th with
Nick Sleep and Qais Zakaria as leading fund managers.
Nick Sleep along with Qais Zakaria ran Nomad Partnership successfully for 14 years and compounded the wealth of their partners at 25% CAGR. His letter to shareholders holds wisdom which is tough to grab and even tougher to implement. I have included some case studies and some behavioral finance guidance explained by Nick in layman language.
2001
Philosophy
“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.”
Eg -
International Speedway – In
discounting growth of just 3% to 4% the market valued the business as if it was
just an average firm, when in our opinion International Speedway is a
rock-solid franchise with improving economics and could be a multiyear winner
for investors that are patient enough to wait.
Quote- A little Wonderful Advice - “When
there is a stock-market boom, and everyone is scrambling for common stocks,
take all your common stocks and sell them. Take the proceeds and buy
conservative bonds. No doubt the stocks you sold will go higher. Pay no
attention to this – just wait for the depression which will come sooner or
later. When this depression – or panic – becomes a national catastrophe, sell
out the bonds (perhaps at a loss) and buy back the stocks. No doubt the stocks will
go lower still. Again, pay no attention. Wait for the next boom. Continue to
repeat this operation as long as you live, and you’ll have the pleasure of
dying rich”.
Cost Incentive in Zerox –
When Xerox leases an expensive
printer, it is often in the form of a five-year contract which bundles
equipment, a service contract and financing. However, in a bundled contract
there is some discretion as to how much is attributable to the value of the equipment
and how much should be deferred to later years in recognition of financing,
maintenance and service. One can therefore understand how management, plump
with stock options and growth in earnings per share related bonuses, were
strongly incented to recognise earnings up front and SFAS 13 allowed them to do
this. The value of the equipment was incorrectly raised relative to service,
financing and maintenance which allowed the firm to treat the transaction as a
sale-type lease and required that the inflated equipment value be booked as if
sold. A double whammy of inflated revenues and profits recognised early. This
does not appear to be illegal, although it is hardly conservative. It may even
have mattered less if Xerox had not relied upon the commercial paper market to
fund its receivables business.
New A/C methods –
deep value
The current market valuation of
U$4.5bn is just four and a half years free cash flow or four and a half years
research and development spending. We estimate the capitalised value of the
R&D asset may be around U$7bn or approximately 50% more than the current
market capitalization.
Long term vs short term -- Trading
volume of Xerox stock implies investors own the shares for under four
months on average, a time horizon which implies few investors are
focused on the long-term value of the business but rather are betting on the
next quarter’s outcome. Rich pickings, we suspect, for the patient.
2002
Stagecoach – A
jewel lying in dust
At Stagecoach the fix is relatively
simple: cease investment in poor US operations, sell the worst businesses for
asset value, repay the debt and in doing so return the business to its jewel,
the UK bus operation. Having analyzed many complicated and highly indebted
businesses especially in the US recently, Stagecoach’s problems are relatively
simple, and we have made the firm our largest investment to date
Costco – Win Win
for all
Nick saw robust business with
sustainable growth, efficient management clubbed with fair price.
Business model
Customers pay an annual membership fee
(standard U$45) which provides entry to the stores for a year, and in exchange
Costco operates an every-day-low-pricing strategy (EDLP) by marking up 14% on
branded goods and 15% on private label with the result that prices are very,
very low. 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 cost.
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 profitable enough to self-fund growth of around 14% per annum and not
to have to resort to leases for expansion (The Gap's mistake). This means that
growth will be more measured (none of the 30% per annum purges that populate
the retail industry) and should be more sustainable.
WHAT DIFFERENTIATES COSTCO—1)Low operating cost
2)The key to negotiating terms is that the number of items in a
store (stock keeping units) are fixed at 4,000, and the right to fill one of
these spaces is auctioned, with the supplier that provides the best value
proposition to the consumer winning space on the shop floor! Contrast this to
normal industry practice whereby the supermarket assumes the role of landlord,
auctions space to the highest bidder and pockets the rents (“slotting fees” in
industry parlance).
MOAT- Many supermarkets make their
money from buying from the supplier. Costco makes money from selling to the
consumer.
Having shared the cost savings, the
customer reciprocates, with the result that revenues per foot of retailing
space at Costco exceed that at the next highest rival (Wal-Mart’s Sam’s Club)
by about fifty percent.
At U$30 the firm is valued as a cash
cow, with higher levels of profitability (as capacity utilisation increases)
and modest levels of growth justifying a valuation over U$50 per share.
Heuristics for COSTCO ,the antithesis for many-
1) the company has low margins
2) expensive at 24x earnings- The firm could earn Wal-Mart margins by taking pricing up a little, in which case the firm would be on 11x earnings
3) “Costco has a cost problem”. Costs have
risen as a percentage of revenues in the last few years due to the expense of a
warehouse and distribution system associated with the next phase of the firm’s
growth and the cost of employee benefits and insurance, especially in
California
Numbers speak a lot less about the
quality of business and integrity of the promoters making it a mispriced bet
and favorable one for the Nick Sleep’s of the world.
On Patience
“If Nomad is to have a competitive
advantage over our peers this will come from the capital allocation skills of
your manager and the patience of our investors.” This is repeated in almost
every letter published. Morgan Housel also in his book “Psychology of Money”
refers to the time advantage that Buffett had. It is ultimately time which
compounds money if deployed in right manner.
Blood in autumn- “During the
late summer and autumn, when investors were at their most depressed, we made
several new investments and, in some cases, added to existing holdings.
Although time will tell, this period may mark the end of investors’ mood swing
from euphoric at the turn of the millennium to manic depressive almost three
years later”
2003
Returns - Long vs. Short run – Warren’s
letter reference “and shuffle the years around and the compounded
result will stay the same. If the next four years are going to involve, say, a
+40%, -30%, +10%, -6%, the order in which they fall is completely unimportant
for our purposes as long as we all are around at the end of the four
years”, as we, at Marathon.
Holding period- Over
a five-year time frame and even this may be a little short compared to the
average holding period of the underlying investments which is presently around
ten years (inflated by a dearth of sales).
On Management - Quality of managerial
character is therefore important to avoid capital misallocation and
it is in the search for such character that we asked an investment bank to
perform a simple company.
Weetabix vs. CornFlakes
Continuous marketing expenditure vs
Kellogs to meet short term earnings goal. Value creation is often most
sustainable when it is built slowly, and notably last year Weetabix became the
largest selling breakfast cereal, overtaking Corn Flakes seventy years after
the company’s foundation.
Free cash flows
The predominance of free cash flow has
allowed market interest rates charged to the most indebted businesses (the
so-called junk bond spread), the highest for a generation between the end of
1999 and 2003, to decline to more normalized levels and it is the
shares of businesses perceived to be in the worst condition that have bounced
the most
Methodology
–Value investing and Margin of safety
“Our aim is to make investments at
prices we consider to be fifty cents on the dollar of what a typical firm is
worth. Capital allocation by investee companies must be consistent with value
creation and, if this is the case, we expect that the real value of the
business (the 100 cents value) could grow at around 10% per annum. The effect over
five years will be to compound U$1 of value into U$1.62, and companies that can
build value like this are normally rewarded in the market with a fair valuation
(i.e., are priced close to U$1.62). The prime determinants of outcome are price
(sticking to 50 cents on the dollar) and capital allocation by management”.
2004
Portfolio
Allocation
“In reality opportunities in which we
are comfortable to deploy capital are rare, and the highest conviction ideas
the rarest of them all. If you know you are right, why would you not bet a high
proportion of the portfolio in that idea? The logical extension of this line of
thought is that Nomad’s portfolio concentration has at times been too low. We
would rather results were more volatile year to year but maximized our rolling
five-year outcome.”
EDGE -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. Sustainable competitive advantages are usually a product
of analytical and or psychological factors.
“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, behavioral)”
BAAP -
Yes or No - In paying up for
excellent businesses today, investors are already paying for many years growth
to come, in the hope that, as the saying goes, “time is the friend of a good
business”. Even though prices are generally high, the trick is to do the
work today, so that we are ready.
41% of assets are invested in “difficult
to copy” franchises such as TV stations, newspapers, magazines or a
motor-racing track; 31% of the fund is invested in asset backed
businesses such as hotels, casinos, conglomerates or those companies
where balance sheet cash forms a large portion of the current valuation; and
finally 22% of the fund is invested in deep value work outs where profitability
is temporarily depressed, and where the firm has sizeable amounts of
debt. In aggregate these investments are priced in the market at around 50% of
what we believe the businesses to be worth.
“what you are trying to do as an
investor is exploit the fact that fewer things will happen than can happen”.
The reason behind Costco being largest allocation in portfolio
was certainty in growth it had.
Growth vs. Value –Subjective definition
Value investor in the sense that we
like to buy stocks at half price. But the largest holdings would be described
by most of our peers as growth stocks.”
If its value vs growth , the loser is
you. Growth is part of the value judgment, not a separate discipline.
“Our definition is that a business is
worth the free cash flow that it can be expected to generate between now and
judgment day, discounted back at a reasonable rate.”
The cheapest stocks a decade ago, but
no value investor owned them. Eg Dell, PMC, EMC etc .Fear of failure of such
stocks A study by Michael Goldstein at Empirical Research, a research
boutique, claims that 48
2005
The probability of growth stock
failure (company growth slowing) is as high as four in five over five years and
nine out of ten over ten years. Probability of failure is
lower than for most growth stocks
Error of omission
- The answer lies in analyzing not
the effects and outputs of a business, but, digging down to the underlying
reality of the company, the engine of its success. That is, one must see an
investment not as a static balance sheet but as an evolving, compounding
machine.
The Robustness
Ratio- Robustness ratio is a framework he used to help think about the size of the moat around a company. It is the
amount of money a customer saves compared to the amount earned by shareholders.
As seen in case of Costco , Geico
provides us with similar case study as Warren says- “Indeed, GEICO
delivers all of its constituents major benefits: In 2004 its customers saved $1
billion or so compared to what they would otherwise have paid for coverage, its
associates earned a $191 million profit-sharing bonus that averaged 24.3% of
salary, and its owner – that’s us – enjoyed excellent financial returns.
The robustness ratio, defined as the
combined distribution to customers and employees (through a profit share or the
like) divided by the distribution to shareholders, is in GEICO’s case about
1:1.
A Costco cardholder saves somewhere in
the region of US$175 per year by shopping at Costco in return for an annual fee
investment of US$23, or a net gain in the region of US$150 per cardholder per
year.
Mental Heuristics
in investing which leads to misjudgments:
1) Group
psychology- Witness the waves of massive overinvestment such as
occurred in the Thai cement industry in the mid 1990s, and the US telecom and
technology companies in the late 1990s. It appears to us that once one company
starts building, they all do through fear of missing out. Once Siam Cement had
built all the capacity Thailand could need there was no need for Siam City
Cement to join in. Let alone TPI Polene. But they all went mad. Combine social
proof with envy and the financial incentives available in the stock market and
that’s a recipe for a sizeable mistake
2) Availability
–It is tendency to over-weight the vivid evidence or the evidence easily
obtained. In the markets, investors tend to latch on to what can be measured,
aided by the accountants and to some extent by their own laziness. But there is
a wealth of information in items expensed by accountants, such as advertising,
marketing and research and development, or in items auditors ignore entirely
such as product integrity, product life cycles, market share and management
character etc
3) Probability
based thinking – To quote Charlie “the right way to think is
the way Zeckhauser plays bridge, it’s just that simple”. He thinks via
decision trees and attaches probabilities to the various branches. And as the
facts change, change the probabilities. Understanding the value of a company
involves assessing the likely outcomes given management behaviour and
competitive forces and weighing the probable outcomes in a valuation. So, an
inability to arrange outcomes in probabilities is a considerable error causing
bias in investors decision making processes and is behind many mis- valuations
4) Patience - Jack
Bogle, founder of the Vanguard Group, claims that the holding period for stocks
is down to 10 months and the average mutual fund is held for 2 years. Buffet
highlights the same in shareholder’s meet on being asked what
separates you from average investor and Warren replies “patience”.
Group psychology example-“Influence:
The Psychology of Persuasion” by Bob Cialdini –cartoon experiment-The size of
the crowd increased, so the proportion of passers-by that stopped and looked
up, at nothing, increased too and increase was non linear.
On psychological
advantage – “Patience,
social proof, vividness and probability-based thinking are the four
psychological hurdles I have chosen to highlight and I think we understand
these perhaps a little better than the average investor out there”
Probability,
Patience and Aphorisms “Distinguishing
features of probabilistic players include a focus on process versus outcome , a
constant search for favourable odds and an understanding of the role of time.” That is Patience.
“Success in a
probabilistic field requires weighing probabilities and outcomes – that is an
expected value mindset.”
“One key to
success is a high degree of awareness of the factors that distort judgement”-Michael Mauboussin, Legg Mason Funds
Management
2006
On
Price Prices are a
language, and the U$20bn equity market valuation of Phelps Dodge states that,
with no margin for error, the business will earn record levels of free cash
flow for the best part of the next decade and with no decline (in nominal terms)
in terminal value. Maybe so, but the frequency with which investors change
their mind implies this is hardly a stable statement of fact.
5 Year Holding period thesis –
“Perhaps in large high quality growth businesses that appear cheaper to us than
for many years. It is for this reason that Nomad’s largest holdings are
dominated by traditional growth stocks, in contrast to five years ago when we
owned the detritus of the New Era boom.
It is interesting to note that five
years ago although the most despised stocks were extremely cheap, each
individual opportunity was relatively small (our investments in Stagecoach and
Midland Realty were seven-baggers but the opportunity size was perhaps U$20m
each). Today the discount to fair value of the most despised stocks would
appear to be much less (doubles over five years are more likely than
spectacular multi-baggers) but the dollar size of each opportunity may be
greater.
Amazon case study
Valuation and Vision of Bezos-As
Buffet often says “In hindsight, everyone is a genius”. Same goes in this case
study. Amazon, where valuations were dirt cheap as Mr Market valued short term
cash flows over the long term. To quote Bezos from annual report 2006-
“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 an example of a very important decision that cannot be made
in a math-based way. In fact, when we lower prices, we go against the math that
we can do, which always says that the smart move is to raise prices. We have
significant data related to price elasticity. With fair accuracy, we can
predict that a price reduction of a certain percentage will result in an
increase in units sold of a certain percentage. With rare exceptions, the
volume increase in the short-term is never enough to pay for the price decease.
However, our quantitative understanding of elasticity is short-term. We can
estimate what a price reduction will do this week and this quarter. But we
cannot numerically estimate the effect that consistently lowering prices will
have on our business over five years or ten years. Our judgment is that
relentlessly returning efficiency improvements and scale economies
to customers in the form of lower prices creates a virtuous cycle
that leads over the long-term to a much larger dollar amount of free cash flow,
and thereby to a much more valuable Amazon.com. We have made similar
judgments around Free Super Saver Shipping and Amazon Prime, both of
which are expensive in the short term and – we believe – important and valuable
in the long term.”
Valuing
Amazon-FCF = US $500 m
and US $500 m is after all investment spending on growth initiatives such
as capital spending, but also research and development, shipping subsidy,
marketing and advertising and price givebacks.
Cancel the discretionary growth
spending and instead return around US $800 m per annum to investors after
taxes. An operation that was able to produce cash flow on such a basis might be
worth US $10bn or so, and along with Amazon’s other assets would imply a share
price of around US $26. In valuing the business at these prices, as occurred
last summer, investors are saying to Amazon management “your growth spending
has no value, you may as well turn yourself into a cash cow”! This is an odd
statement to make for a business growing revenues in excess of twenty percent
per annum.
Mouse to Elephant-Basic building block
is combined with the scale efficiencies shared model (which increases the moat
as the firm grows), customer centric orientation of the firm’s founder, as well
as his healthy disdain for Wall Street
What
differentiates Nomad - The
polarity of the portfolio, with several large, simple, high conviction
holdings, and a tail of more complicated and less certain ideas (but which may
have more upside) is likely to be a feature of Nomad. Notably concentrated: the
five largest holdings account for half the portfolio and the top ten around
three quarters. The tail of around twenty other holdings includes baskets (such
as Zimbabwe), several distressed turnarounds and rats and mice from the early
days.
Rhetoric or facts- A billion
heartbeats it is: careful how you use them!
Scaling Law in
investing
1) 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.
2) 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 re-engineering.
Eg-Costco, Amazon
Skin in the game- One reason for this is that the fund is
over-whelmingly (over eighty-five percent) invested in firms run by their
founders or first-generation management. We would have a bias
toward founder-managed businesses.
2007
On mistakes
“If I had to live
my life again, I’d make the same mistakes, only sooner”. -Tallulah Bankhead
In dealing with mistakes the best
state of mind is non-judgmental forgiveness. In investment terms, once lessons
have been learnt, mistakes can be put on a price earnings ratio of one and the
resultant, conditioned, good behavior on a ratio of more than one. In other
words, mistakes become net present value positive.
“We do not justify them, but we do not
condemn them either. Indeed, they are best not judged. Our model is to learn
from our mistakes and what we learn we hope to give to you, in better
performance results”.
MDC Case study - In the 1980s his firm built
condominiums and apartments and as the property cycle matured reinvested
profits and available borrowings in land for development. By the early 1990s,
revenues had almost halved from the 1988 peak and the firm was left with too
much debt and tracts of undeveloped land.
Rectification
The family learnt from its experiences
and since then the land bank has been kept to a minimum, debt has been used
with great reluctance, and equity capital freed from house sales has been used
to equity fund the next venture, pay dividends or, to a greater extent,
retained on balance sheet. Whilst management may have learnt their lesson it
must have been galling to have pointed out by an investor at a recent
presentation “you are going to run out of land”.
Result
The MDC share price has risen ten-fold
in the last ten years, despite recent industry wide declines in share prices,
and today the firm is one of the best capitalized in the industry.
