Lessons From Nick Sleep P1

I want to cover Nick Sleep's Letter's but I won't cover them all at once for the sake of brevity. I will use a mixture of quotes from the letters and give my own thinking on how I'll use these bits of wisdom to make myself a better investor.

I won't cover his analysis of each of his holdings as this will be counter-productive for my learning. In areas that I feel are in my circle of competence or where I'd like to know more, I will cover analysis. In areas that I'm not as interested in, I won't be as detailed.

I'll use a dash to show direct areas of insight from the letters then discuss my own thoughts on the matter in normal form.

The first series of letters is from 2002.

Letter 1:

- Talks mainly about two companies that share a few common traits: family-owned, priced far below intrinsic value, good runway into the future

The more I learn from the great the more divergence I see. Family-owned to me is similar to founder CEO. Both of these groups will have a lot invested in the company. They feel ownership, they have a deep relationship with the success of the company. A failure for the company moving forward would likely affect them much more deeply than a normal CEO who was put in place by the board.

Priced below intrinsic value is pretty common for all value investors. You try and find something that will be valuable in the future, and discount it at your rate of return over a long time period. Then buy for 50% or less of that number and there is your margin of safety. All good long-term investors do this.

The good runway concept is one that I'm just starting to incorporate more into my own investing. To me, it prices out a lot of large companies. For my own portfolio, the only mega-cap that I have is Alibaba. Even though its market cap is ~700b, I think it still has a great runway and will end up being an even bigger cash cow than it is now when growth begins to stall.

However, most of the new ideas I'm working on and when I'm screening, are usually micro and low caps in the 200m-1b range. I'm looking for true 100-baggers. If you want something to go up that much, you need a very long runway. 700b isn't going to turn into 70 trillion. But 200m can definitely turn into 20b. The hunt goes on!

Letter 2:

- Performance of value funds likely to be less than the market on booms, and will perform better during downturns and bear market.

I'm excited to see how my portfolio does in downturns. Since my portfolio hasn't lived through any prolonged bear markets it's a little hard to say. But since most of what I own is underpriced as opposed to overpriced, I think it will act somewhat similar to what Mr. Sleeps' portfolio did.

- Had a great quote from Where Are The Customer's Yachts: "“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”.

- The key here from Sleep is to "Pay no attention," the market simply doesn't do this

- From Nick Sleep: "The dysfunctionality of the short term investor was neatly described to us recently by a fellow long term value investor. Imagine, he said, that you knew with 100% certainty of outcome, that on January 1st next year a company would come by some good fortune, perhaps a government contract or license award, which would result in the price of the share quickly rising tenfold. You and I would buy the shares today and wait. However, to the short-term investor, the utility of this piece of information would be naught until after this year is ended. This is because he feels he is required to perform this quarter, next, and by year-end through fear that sub-par performance might cost him his job. A share that may be flat for the balance of the year is therefore of no use to him. This tale illustrates the dominant dynamic in the markets today: investment time frames are very compressed, and few investors seem bothered to assess the real value of a business but instead respond to the latest data point to determine share price direction. This is momentum investing and is the mechanism by which expensive shares become very expensive, just as cheap shares may become very cheap."

Not much insight to add here as Nick Sleep did all that for you with the the quote above.

- Discusses financial engineering by Xerox. Booked revenue and profits above actual numbers.

- Invests in great management teams with high R&D costs, therefore revenues and income will be lower short term, but they're fine with that. But their shareholders need to realize the profits from the companies they own, may not show up for a few years.

This is my portfolio to a T. I realize that tech for instance will probably beat my portfolio over the short run. But I think everything I own will be a lot more valuable in 10 years than now and can withstand down swings better than tech. I have a few holdings that will take years to unlock the full value, and I'm fine with waiting on that to occur rather than jumping into expensive tech companies.

Letter 3

- "It is almost certain, however, that over any time frame the investment performance of the Partnership will only approximate the change in the real value of our companies, and even then it may be only a very general approximation. Some years our investment performance will exceed growth in the value of our businesses, in others, the reverse may be true "

- Doesn't use derivatives or shorts

- Tries buying businesses priced 50% of what they value it at

- Most companies they're holding at this points are paying down debt, buying back shares or have insider buying and debt or equity repurchase

This is good business economics. Obviously paying down debt sucks as it reduces the bottom line, but it has to happen. Share buybacks are a great sign the business is trying to increase shareholder value, provided they are buying shares when they are actually cheap, and not doing buyback at any price for the sake of doing buybacks.

Insider buying is always good as is a large % of insider ownership. This means that insiders, who clearly know more than any outsider have some information that leads them believes in the business in some time series. Hopefully, they hold on long-term.

- Costco has everyday-low-pricing-strategy EDLP which gives it a huge competitive advantage and grows loyalty to the brand

- Standard strategies are high-low pricing where companies will try and determine what customers buy based on pricing things differently.

- Costco's EDLP makes pricing fair. You know you will always pay 14-15% above wholesale pricing and that's how it is. Standard strategies cause confusion, Costco simplifies things

- Uses some simple metrics to determine Costco's TAM at the time: "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. As to the potential for growth the firm has 21 stores in Washington State which houses just 2% of the US population. This density coast to coast implies room for around 1,000 US stores (currently 284) and 200 stores in the UK (currently 14) although planning regulations may not allow for this. Even then Home Depot, the largest DIY store in the US currently has 1,500 stores. At 10% growth per annum, this implies the firm has another 13 years of growth ahead. "

Costco is a business that interests me greatly. I'd love to add a business that has a "low cost provide" moat to my portfolio but I haven't seen anything that tickles my fancy. Given the great names involved in Costco, and the fact I actually use Costco and like it, I would love to get my hand on some tasty shares in this great company. Unfortunately, I'll probably be on the sideline for a while on this one.

I'll keep on studying Costco and get my target price down and keep on waiting!