Lessons From Nick Sleep P2

June 2003.

- Nick noticed that investors were greatly depressed and prices were low. He saw many opportunities to make money barring a catastrophe

- He's indifferent toward short-term performance. Prefers 5 years, but think that's still probably a little short.

- When looking for companies with qualities that will create sustainable value he asks management the following questions: "what are returns on incremental capital and the longevity of those returns? Is management correctly incented to allocate capital appropriately? And what is discounted by prices?"

These are great questions that I already ask myself when analyzing a new business. I look for high ROIC that has been sustained for 10 years or so. I look to see what the business's sales, income, EPS, cash from operations, and equity are over the last decade or so. No, you can't simply extrapolate out of this that the growth will be maintained forever. You must look at the total available market and try to figure out how much longer a company can grow at its current trajectory. For prices, I like to try and grow earnings at a realistic number for 5-10 years then discount it back to present value using an internal rate of return (used to be 15% but I'm looking for 100-baggers, so I've been using a much larger number than this, usually around 25%)

- "All too often however management become sidetracked and misallocate capital usually through diversification or in the words of Peter Lynch, “diworsification”. The result of which is that aggregate returns on capital decline and the share price falls to discount poor performance. Quality of managerial character is therefore important to avoid capital misallocation "

This point is very interesting to me as I'm looking more and more for spawners. When I'm looking, I'm making sure to pinpoint what spawners the company has created and how well these spawns have done. If they're all duds, then they don't have success as a spawner and should be a pass, unless they are very good at one thing.

He goes onto one very interesting criterion for searching for companies that fit their own criteria:

- No increase or decrease in shares outstanding in the last 10 years

I understand not wanting to dilute via equity share, stock options but I don't see buybacks as a negative. There can clearly be a negative way to execute buybacks. If the company is severely overpriced, then buybacks are a waste of capital. Good management should initiate buybacks only when it makes sense. Unfortunately, buybacks are now seen as industry norms rather than actual value creation vehicles.

- Other attributes they look for are businesses with reasonable economics, low valuations, and seemingly stubborn resistance to outside influence.

Weetabix

- Zero share dilution since 1930's

- High marketing spend was able to stave off competition

- Runs factories with fifty percent capacity redundancy to maintain production standards and delivery reliability

- This higher CAPEX meant lower returns, but it also meant they had a great reputation going forward

- Nomad valued the company around 75 pounds per share and bought it at 20 pounds per share. The reason for this massive discrepancy in price was that the stock sold on Ofex (similar to Pink sheets) rather than on London Stock Exchange

- For this reason, large institutions were mainly out, and therefore it was a tougher business to get information about

I love this. This is how I feel I can get a large advantage over larger institutions. I have a few businesses in my portfolio that the retail person has never heard of and likely won't know about them for a few years. I'm fine with this. It means it's not well covered by analysts, and therefore doesn't have the share price appreciation that is associated with analyst "ratings." I get downright giddy finding an absolute gem that I can google and barely anything comes up.

I plan on having a portfolio full of these over my lifetime.

December 2003

- They learned from Bill Miller to analyze failures more thoroughly than successes

- "As investors we all do this to some extent, winners flatter the ego regardless of the reason they went up, whilst we all feel bad about the losers. "

I remember Seth Klarman discussing this in a clip. That you have to try and remove ego to some extent in an investment decision. Because when you buy something, you are essentially saying the person selling to you is wrong. So there is ego involved, but you have to bypass that and ignore flattering yourself too much!

The letter then goes on to discuss the returns they were looking for. He was looking for equities that were 50% off that could go 10% per annum. This would give them a return of 26% per annum. Great returns. He goes on to say when he's wrong it's usually because of capital allocation misjudgments such as poor share repurchases/debt repayment.

- "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 "

These are the usual determining factors of most successful long-term investors:

1. Buy when the business is under intrinsic value (50% for Nomad, I use this number for my investing as well)

2. “The big money is not in the buying and selling, but in the waiting.” - Charlie Munger. People seem to be obsessed with always doing something, making new investments, trying to find easy and quick fixes. As Munger's quote makes distinctly clear, you need to wait on your idea to form, and then over time, if your decision-making was sound, the share price will follow the success of the business you invest in. Or if the share price isn't where you want it in order to generate the returns you're trying to achieve, you wait for something to happen that will cause the price of the asset to reach what you want in order to generate great returns.

3. I feel I touched on this a bunch more above.

- "At the time of writing our internal calculation of the price to value ratio of the Partnership is 65 cents on the dollar, approximately the same as at the end of June despite fund performance."

I find this pretty intriguing as I like breaking down my portfolio and looking at the "sum of it's parts" to find how where it's valued. I may end up doing this in the future, but it causes me a bit of cognitive dissonance. The reason being that I'm moving towards the Charlie Munger way of not selling just because your business is past fully valued. I want to have great businesses that I can leave alone to keep functioning and making more and more profits into the future. If the market wants to put a massive price tag on that I have to subjectively decide whether or not I want to sell.

This is a point I'm learning more and more about. I feel time and experience will help me shape my decision-making. I'd say I'm more likely to sell based on if I find better ideas than if something is overpriced. But as my portfolio changes and market dynamics change, I'm sure that my decision-making will change (hopefully for the better!)