Nick Sleep Letters : Seneca of the Wall Street ! (Final Part)

Nomad’s Stagecoach, Conseco and Keynes

Conseco went bankrupt after losses in its manufactured housing loan securitisation trusts impaired capital at its insurance company and A.M. Best, the insurance industry rating agency, declared the business inadequately capitalised. Our analytical mistakes were multifarious, but the most serious was to anchor on analysis at the time of purchase to justify continued holding. The immediate dollar loss was around U$5m for investors in Nomad. However, the opportunity cost loss, the dollar loss adjusted for subsequent Nomad performance (a fairer reflection of real costs) is around U$10m.

Stagecoach was a success in the sense that shares purchased at 14p were sold at a high of around 90p. That is until one looks in the Financial Times to be reminded that the shares currently trade above £2.50. The mistake was to leave £1.60 on the table and was also caused by anchoring on the original purchase decision analysis (which required a value above 14p), rather than thinking about the destination for the business in years to come. The opportunity cost of the Stagecoach mistake is broadly U$12m today (and counting).

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).

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. And what did we learn in Investing 101 from Lord Keynes: “better to be generally right than precisely wrong”! At the time we were making these errors we would have held Keynes’ quote as true. One has to be so careful; sometimes these mistakes are very insidious. Keynes’ dying words were reported to be “I should have had more champagne”.

 

How to avoid mistakes

Noticing the mistakes is a huge advantage and so rarely done. What makes up the mistake includes

1)denial, that is, the reinvention of reality in the mind because the truth is too painful to bear; 

2)anchoring, that is a static, historic vision of a problem; and

3)drift, that is how small, incremental changes in thinking build into a big mistake.

 Add judging to the list as well, in the sense of condemning or exalting: that disposition stops a lot of rational thought, and it is almost ubiquitous.

 One trick to help see the world more clearly is to invert situations.

 “Give me the strength to accept that which I cannot change, The courage to change that which I can, And the wisdom to tell the difference.”

 The biggest risk in investing is the risk of misanalysis and to seek control of this risk through the quality of research, especially through applying what you have learnt. The quality of research-based decisions overwhelmingly determines whether you will do well in the long run. But it has almost no influence over the timing of these results.

 

2008

Air Asia Case Study

Air Asia is Asia’s largest low-cost airline and is probably the lowest cost airline in the world. The firm has borrowed heavily from Southwest Airline’s model of operations (a point-to-point network configuration, on-line ticket sales, no reserved seating, one plane type). The effect is that costs including fuel are around 3c (US) per seat per kilometer (as of December 2007). Costs are very important when the product is, more or less, an undifferentiated commodity, and 3c compares with around 4.5c at Ryanair, 5.5c at Southwest or more importantly 4.5c at rival Malaysian Airlines. This cost advantage is shared with the customers in the form of low fares.

“Air Asia is an example of scale-economics shared, which like Amazon, Costco, Carpetright and elements of other businesses in the portfolio (Geico, Nebraska Furniture Mart) have come to dominate Nomad (around 45% of the portfolio)”

How – Lowest cost jets –A320s clubbed with high population ie high demand and rising per capita income

MoS - price of the shares in the stock market today, which appears to value the firm at a meaningful discount to the value of the company owned fleet of planes

Other than this MBIA and Games Workshop case study highlights similar traits- one hit another just another risky value bet where antithesis is more likely to play out. MBIA’s dilution and shorting risk outweighs the reward and hence was sold by Nomad.

 

On duration

Tom Stoppard, the playwright, is credited with saying “If an idea is worth having once, it’s worth having twice” and it is in this spirit that we will quote Jack Bogle’s work again. Investment holding periods by institutional investors have declined from an average of seven years in the 1950s to less than a year by 2006, according to the Bogle Institute :

“Then, prophetically, Lord Keynes predicted that this trend would intensify as even ‘expert professionals, possessing judgment and knowledge beyond that of the average private investor, would be concerned, not with making superior long-term forecasts of the probable yield on an investment over its entire life, but with forecasting changes in the conventional valuation a short time ahead of the general public.’ As a result, Keynes warned, the stock market would become ‘a battle of wits to anticipate the basis of conventional valuation a few months hence rather than the prospective yield of an investment over a long term of years.’  

“Simply put, what went wrong was a pathological mutation in capitalism—from traditional owners’ capitalism, where the rewards of investing went primarily to those who put up the capital and took the risks—to a new and virulent managers’ capitalism, where an excessive share of the rewards of capital investment went to corporate managers and financial intermediaries.”

 

2008  Lehman Brothers collapse

Anchoring among investors

It is unusual for investors to repeat the last mistake (dot com behavior) so soon. Psychologists argue that the last mistake is so vivid that, if anything, we tend to over- correct, as anyone with a whisky-hangover will tell you. The insanity of bubble-like valuations was well captured by Scott McNealy in a 2002 interview in Business Week when he was still CEO of Sun Microsystems (source: James Montier, Société Générale, Cross Asset Research Group),

“But two years ago we were selling at ten times revenues when we were at U$64. At ten times revenues, to give you a ten-year payback, I have to pay you 100% of revenues for ten straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes that, with zero R&D for the next ten years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at U$64? Do you realize how ridiculous those basic assumptions are? You don’t need transparency. You don’t need footnotes. What were you thinking?”

 

Risk management

They manage risks over the holding period of an investment (say selling foreign currency to match the expected five-year holding period of a foreign stock).

“If interest rates do rise in Thailand in 2008, then the short term prospects for our shopping mall, Mah Boon Krong Holdings, may temporarily decline, but it is far from clear that that event is a risk to business value in five years’ time.”

Controlling the risk of mis-analysis of the big things – value per share of an investment many years out – not spotting wiggles on the path along the way.

 

Momentum investing

Nick narrates the story of purchasing Savoy Hotel via auction and compares it with regular momentum investing.

“‘S’ for Savoy, ‘S’ for Sleep (such vanity – first mistake), and well, I have always had a soft spot for the hotel (second mistake) and whilst I had no idea what the intrinsic value of such an item might be (third mistake), I placed a bid (fourth mistake).”

On the first day the prices rose from £350 to £500. On the second day they started down a little at £400 but rose to £800. And on the final day they started at £600 and rose to £850.

WHY? First, scarcity, as the auction continued the stock of available ‘S’s declined. Second, social proof, once one person had set a high price it was seen by others to endorse the value of the item and they too could pay a higher price knowing they were not alone.

 

Comparing momentum with Nomad investing-

1)     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.

2)     Fifty-five percent of portfolio companies are either repurchasing shares or have had meaningful insider buying. There is huge growth embedded in the portfolio and normalized profitability is high. Despite these attractive prospects the average investor rents shares in our firms for fifty-one days. Nick highlights his analytical as well as psychological advantage.

“Our shares are cheap because investors prefer to chase the new booms surrounding Chinese urbanization and associated natural resources demand. We have no idea whether purchases of resource stocks at current prices will prove profitable for these investors. However, we do know that our stocks are selling at bargain prices.”

 

Think about the inputs to investing rather than the outputs.

It is in times like these that the hard psychological and analytical work is done and the partnership is filled with future capital gains: this is our input. The output will come in time. Those with a rational disposition may not find it too hard to feel good today.

As market crashed in 2008, Zak and Nick writes how tough it was for them, how five years of gains was washed out in matter of weeks, and how to cope up with such black swans.

Whether business values rise faster than share prices, or share prices fall faster than business values, either way the effect is the same: a growing differential between the price of a business in the stock market and its real value. Their focus was on improving the price to value ratio of the partnership overtime and make it 10 bagger with time.

“Capitalism does not teach slack, it teaches optimisation”. That is capitalism teaches that assets must be worked hard, outputs maximised, returns as high as can be. We all see so much of this line of thinking that it has become part of the landscape so familiar as to not be noticed any more.

The best activities might be those that refresh the mind, broaden horizons and reinforce good habits

Incentives. Incentives. Incentives.

The incentives are helpful if they raise the probability of a favourable destination for investee firms. Scale economics shared works across industries too with the effect that load factors at the low-price Malaysian airline, AirAsia, are superior to high-low flag carrying airlines. And it works online: Amazon have deployed it so well that Amazon’s operating costs (per dollar of sales) plus its operating margin are less than some of its high street peers’ costs (per dollar of sales). This offers the prospect that, in theory, Amazon’s high street peers could price their products at net income breakeven and still not undercut Amazon’s prices or profitability.

 

2009

Empty vessels vs Quieter approach

Amazon and Costco do not advertise (no shouting here); Berkshire Hathaway and Games Workshop do not provide earnings guidance (popular with baying fund managers and stockbrokers); Amazon, Costco, AirAsia, Carpetright, and parts of Berkshire give back margin to the customer, we would argue that is a pretty humble strategy too. In other words, around two thirds of the portfolio is invested in firms that in some major way shun commonplace promotional activity and they are no less successful as a result. Vis a vis the advertising spend was U$5.3bn in 2008, or U$630 per car delivered for GM

Over-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. Real diversification is offered by index funds at a fraction of the price of active management.

Mantra - 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.

Error of omission rather than commission :

1.     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 returns. Taking this model and applying it to Wal-Mart would miss the company’s source of success entirely as the strategy of price givebacks did not change from year to year; culture plays a part in the continuity of a successful price giveback strategy and factors such as culture, because they are hard to quantify, often go undervalued by investors; investors presume regression to the mean starts at the time of their analysis or, in year three or five of a DCF analysis. Investors use valuation heuristics rather than assess the real value of the business.

2.     Structural or behavioral: Active fund managers have to look active. One way to do this is to sell Wal-Mart, which appeared expensive (but actually wasn’t), to buy something that appeared cheaper (but err, also wasn’t); investors are not long-term and did not look further than the next few years or, more recently, few quarters. Evidence for this can be gleaned from the average holding periods for shares which stands at just a few months; fund managers wish to keep their jobs and espousing a ten-year view on a firm risks being a hostage to fortune; marketing folks require new stories to tell and new stocks in the portfolio provide new stories.

3.     Odds or incorrectly weighing the bet: Investors tend not to believe in “longevity of compound”. Empirical Research Partners, an investment research boutique, discovered that the chance of a growth stock keeping its status as a growth stock for five years is one in five, and for ten years just one in ten. On average, companies fail.

 

Weighting the Information

Investors see the information but, they incorrectly weigh the information. There are very few business models where growth begets growth. Scale economics turns size into an asset. Companies that follow this path are at a huge advantage compared to those, for example, that suffer from Barbie syndrome. Put simply: average companies do not do scale economics shared. Average companies do not have a healthy culture.

 

Nomad after 18 months of bloodbath had various choices –

“When Zak and I trawled through the detritus of the stock market these last eighteen months (around a thousand annual reports read and three hundred companies interviewed) we had four main choices: add to existing holdings, invest in new firms, invest in growth businesses, invest in cigar butts. Overwhelmingly we have preferred our existing businesses to the alternatives. Of course, such a conclusion will only make sense if the businesses in which we have invested have great prospects and the shares are cheap.”

 Darwin found, it is hard to let the facts speak for themselves, reject the established way of thinking and to do so in good conscience. And it is a blessing for us that the crowd have rejected something so obviously right as investing at its simplest. Indeed, such is the lure of, what might be called, professional fund management techniques.

 

Portfolio allocation post 2008- The Partnership has twenty investments but a noticeable concentration in ten, which make up around eighty percent of the portfolio, and for those with sharp eyes around thirty percent of the Partnership in one investment. Although the bulk of the Partnership is listed in the United States, look-through revenues are far more diversified: US dollar revenues forty-seven percent, Euro and Swiss Franc revenues twenty-one percent, South East Asian currencies sixteen percent, Sterling ten percent, Yen three percent and others three percent. There are perhaps six main industry groups and their weightings are as follows: internet thirty percent, consumer staples sixteen percent, consumer discretionary fourteen, business services thirteen, insurance and finance eleven, and airlines eight percent, with a tail of smaller groupings

 

Being a decade old now, and after a lot of reading and analyzing thousands of firms, Zak and Nick decided to let older investments run and compound wealth and move towards in activity.

 

2010

 Explained competitive advantage from Costco case study. When Zak and Nick went to meet Jim Sinegal, Sinegal gave them copy of memo of Sol Price (founder of Fed mart) which said:

 “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”.

 

Valuation framework and business culture

When investors value a business they have in their minds, consciously or not, a decision tree with the various branches leading to all possible futures and probabilities attached to those branches. The share price can be thought of as an aggregate of the probability weighted value of these branches. The problem, as Santa-Fe Institute scientist Ole Peters most recently pointed out (SFI Bulletin 2009, volume 24), is that this is not an accurate representation of what the future will be! The next step for the company will not be to visit all of those branches simultaneously. In reality the firm in question will only visit one of those branches before proceeding to the next and so on. Short-term investors spend their time trying to handicap the odds of each branch.

If some businesses, once they have progressed down the first favorable branch, stand a much greater chance of progressing down the second favorable branch, and then the third, as a virtuous feedback loop builds. The process takes time, but a favorable result at any one stage increases the chances of success further down the line, as it were. Think of it as a business’ culture.

 

Eg- Air Asia: The firm was born with a no frills, cost culture with the result that, it is the lowest cost airline in the world: this is favorable branch one. Favourable branch two: the employees take pride in the firm, suggest their own savings and the savings are implemented. Branch three: the savings exceed the peer group and are given back to customers in the form of lower prices. Branch four: the customer reciprocates and revenues rise. Branch five: further scale advantages lead to more savings per seat flown. Branch six: further customer reciprocation. Branch seven: the network builds and crowds out other, less efficient airlines. Branch eight: competitors go out of business.

 “Nevertheless, the effect of this indifference on share prices is to leave long-term success undiscounted (note, share prices are an aggregate of all possible future worlds, not the actual future) and the rewards from that observation may be enormous for the patient few.”

 

Not to take any decision is also a decision!

Whilst a lack of buying and selling may look from the outside that we are not doing anything, the decision not to change the portfolio is an active decision and our research continues as ever.

“Indeed, we find many great businesses available at what seem sensible prices, but, in our opinion, they do not compare favorably with what we already own, and so we move on, constantly comparing what we have with the alternatives, but often, as far as the portfolio is concerned, doing nothing”.

We do promise you this: we are human, we make mistakes, but our mistakes are honest ones.

 

2011

On fears, habits and mental shortcuts

It is so easy to screen out a good idea because of a bad association. As Charlie Munger quipped at a speech given at the same course a few years earlier “the human mind is a lot like the human egg”: once one sperm has entered then all the other sperm are locked out. The human mind has these learnt biases, short cuts, fears, habits, and associations and, in the case of the panelist above, they can stop us from making rational decisions.

 

On terminal value estimation

When investors think about the future of a business, they often have in mind the assumption that growth rates slow with time, as competition ekes away advantages and market places become saturated. Predicted revenue growth rates (used in valuation models) therefore start high and end low. This is especially true for firms that are quite large already.

However, if the rate of growth in internet retailing is a product of attitude, rather than assets, then, the fact that a firm is quite large already does not necessarily tell you that its growth rate is set to slow. The widely held presumption that regression to the mean begins the moment the analyst picks up their pen, risks being wrong footed as a result. Two years of forty percent revenue growth, for example, will result in revenues doubling in twenty-four months and regression to the mean based estimates would be out by almost a factor of two! That did not take long. In other words, although some online retailing firms may be quite large, they may also be quite young. It is this realisation that has partially driven the revaluation of internet retailers these last few years.

Jeff Bezos, founder of Amazon, made the following point in an 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.”

The trick to being a good investor, over the long-term, is to maintain your long-term oriented discipline. Bezos again:

“Our first shareholder letter, in 1997, was entitled, “It’s all about the long-term”. If everything you do needs to work on a three-year time horizon, then you’re competing against a lot of people. But if you are willing to invest on a seven-year time horizon, you’re now competing against a fraction of those people, because very few companies are willing to do that. Just by lengthening the time horizon, you can engage in endeavours that you could never otherwise pursue. At Amazon we like things to work in five to seven years. We’re willing to plant seeds, let them grow – and we’re very stubborn. We say we are stubborn on the vision and flexible on the details”.

 

2012

Information

David Attenborough: “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.”

Attenborough is saying that the human mind trumps endless data collection. We could be more specific: the frontal cortex of the brain, which is charged with rational thought and information processing, can make more sense of the world, given enough time to think it through, than the senses themselves can make sense of the world.

In today’s information-soaked world there may be stock market professionals who would argue that constant data collection is the job. Indeed, it could be tempting to conclude that today there is so much data to collect and so much change to observe that we hardly have time to think at all. Some market practitioners may even concur with John Kearon, CEO of Brainjuicer (a market research firm), who makes the serious point, “we think far less than we think we think” - so don’t fool yourself!

Information as Food analogy- Rangaswami’s analogy is wonderfully provocative: in the cultivation of food there are hunter gatherers who are free to roam, or farmers who put up fences to define ownership; the same is true in information, is this not what patent and copyright law is all about? In the preparation of food we can either choose distilled nutrition or a smorgasbord that allows for the mixing of raw nutrients; the same is true when we are served with a conclusion or instead ask for the underlying data. Information, like food, has a sell by date, after all, next quarter’s earnings are worthless after next quarter.

 

2013

Inactivity as a Source of Value Added

“At the time of our initial investments in Nomad’s investee businesses, the firms were, on average, around fifteen years old. Take out the two grandparents (Berkshire Hathaway and Costco) and the average falls to twelve years.”

“For those used to a more industry- standard level of trading activity, we hope to update you in real time on our level of inaction through our planned “Nomad Inactivity App.”, available only in the Amazon App. store, of course. As Berkshire Hathaway Vice-Chairman, Charlie Munger, says, you make your real money sitting on your assets!”

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.

In these letters Nick has discussed business models, incentive compensation, capital allocation, mistakes, more mistakes, even more mistakes, lots on psychology and how to think, lots on attitude and so on. After facing a lot of regulatory issues Nick and Zak decided to liquidate the fund and suggested the partners to buy the same stocks and keep it for next 10 years.

Nick’s letters provides a fresh perspective about investing and investor psychology which makes him “Seneca of the Wall Street”.