June 2004
- In May, the Partnership had grown to 100m with 16% cash assets.
- "The size of any future reopening will be proportionate to the opportunity set: a meltdown in large-capitalization shares (please), a debt market swoon like the one recently experienced in the US, or an emerging market crisis as occurred a few years earlier, would allow the Partnership to be many times its current size and improve its potential returns. Today, the opportunities are mainly small and mid-capitalization companies, especially in Asia, and mainly turnarounds in nature (which bring with them reinvestment risk once the stock is sold). And so, for the time being, the Partnership will retain its modest size.
When we do reopen, we will write to those that have expressed an interest in investing more. This is likely to occur during periods of market stress and we will have to trust that indications made during rosier times turn into contrarian subscriptions. Very few organizations practice this common-sense approach because they understand how human nature works. They suspect (or know!) the average investor will be bearish at the bottom. There is no point taking that particular horse to water."
Very high cash for a fund. I definitely appreciate when funds have cash on hand if the circumstances are right. It shows that they have the patience to holdout for great opportunities and aren't willing to settle for lower return investments just to appease their partners. Nomad clearly did a good job of getting the right investors on board with their fund so they could run it in a way that would maximize returns over the long haul, which is my focused investing strategy as well.
- "We have holdings ranging from almost 7% to 0.3% of assets. At the time of writing, Jardine Matheson/Strategic and Costco Wholesale are around 6.5% of Partnership assets "
It looks like during the first few years, they were reasonably diversified. I know over the next few years, as they built more and more conviction they eventually focussed mainly on three companies which I'm sure we will get to in the future.
He then goes on to discuss a little bit about the woes of not being able to build a more sizeable position. They got a million of Union Cement which was trading at a MC of 200m and hard around 700m in gross assets. But the position was hard to build because of low liquidity. Shareholders knew it was underpriced and didn't want to part ways with their shares. They initially purchased shares at 1 to 2 cents. A large cement company purchased the company for 10c a share, so they did incredibly well. He does go on to say they wish they could've built the position up to a 10% portfolio weighting and quotes Munger "it is aggravating to just buy a bit”.
I've run through this problem a lot with my investing. Simply because I started with a very small sum of money, and have been adding more from my income. When I started I would only have maybe 1000 dollar bets. But now as my portfolio and cash increase, I'm upping to 4-5000 dollar bets and I have no problem increasing that number as my portfolio goes up. I have a few positions in companies like MU and INMD where If I had the capital I have now I would have at least double the initial position size they are now, oh well!
- "As the cash is invested, portfolio concentration will rise. In theory, if we could find fifty ideas at equal discounts to value, with equal probability (conviction) of value being realized, then they could all be equally weighted in the Partnership. We could all then look forward to a nice smooth rise in the value of our shares in Nomad, free from the swings a more concentrated portfolio might create. But life is not like that. In reality opportunities in which we are comfortable to deploy capital are rare, and the highest conviction ideas the rarest of them all."
He then goes on to briefly discuss the Kelly criterion and how nobody actually uses it because your portfolio balancing would get incredibly high (50%+ in one holding). But then he says "But is this not the right way to think? If you know you are right, why would you not bet a high proportion of the portfolio in that idea?" This is something that I've found very compelling. During these times ideas that can actually make money are becoming rarer and rarer as the market get's hotter. So when I find one, I want to make it large size of my portfolio and have the conviction that yes, this will do very well for me 5-10 years down the road.
- "In our opinion, the massive over-diversification that is commonplace in the industry has more to do with marketing, making the clients feel comfortable, and the smoothing of results than it does with investment excellence. "
Next, he covers the consequences of over-diversification and does an incredible job talking about the pitfalls.
- When you own a lot of different companies your ability to track things like corporate governance, capital allocation, incentive compensation, accounting, and strategy becomes diluted
- When over-diversification becomes the industry norm, bad corporate behavior is thrown under the rug
- “...the best defense is to own enough of the company to influence the outcome. In most cases in excess of 10% of the shares outstanding would suffice. Those that advocate market liquidity of their investments over other considerations might like to bear in mind an investor’s inability to influence outcomes whilst owning a de minimus proportion of a company. Should Nomad continue to grow in size, we intend not to make this mistake”.
- "At National Indemnity (an insurance subsidiary of Berkshire Hathaway), the firm’s ability to write insurance only when pricing is good and stand back when pricing is poor, even if revenues decline by 80% and remain depressed for many years, is a wonderful example of capital discipline and good capital allocation. After all, why grow if returns are going to be poor? However, surprisingly few companies have the strength to just sit it out, or shrink, as the pressure to grow is often overwhelming."
Nomad had a list of 15 great companies they were watching. The main characteristic of these companies was that they had long time horizons for success. They didn't succumb to the institutional imperative of trying to grow just to have 1 good quarter. These were companies that would gladly take a short-term hit if it meant more high-quality growth in the future. He asks a great question "why aren't these companies in the Nomad portfolio?"
- When we think about companies, the over-riding analytical consideration is the quality of the business and quality of management’s capital allocation decisions. The longer investors own shares the more their outcome is linked to these two metrics.
The simplicity of this shouldn't be under-emphasized. Long-term prices are tied to these two things. The focus on investing should be on finding high-quality businesses that are lead by high-quality capital allocators. This is what Nomad did, this is what Berkshire did and the results speak for themselves. In the short-term the market is a voting machine, in the long-term, the market is a weighing machine. Act accordingly.
The main reason he says these 15 great companies aren't all in their portfolio is pretty simple. Price. You pay more for great business as the growth factor will bring in higher multiples. But, given the market is auction-driven, prices oscillate wildly, while business values do not. Because of this discrepancy, at some point in time, a business will be misvalued.
December 2004
During this time both value and growth stocks were expensive. Oddly enough he discusses how the past few years suited "value investors" whereas in the late 90's it suited "growth investors." I find it amusing that this value and growth discussion has lasted decades, and I know was talked about at length even farther back than this. He says that even now (2004) both growth and value stocks are evenly overpriced (sounds like 2021 too, lol). "It is probably fair to say that reinvestment risk (the risk from investing the incremental dollar poorly) is probably higher today than normal."
- "The debate over growth and value is perennial, and quite unnecessary. Warren Buffett got it right years ago: “Whether appropriate or not, the term “value investing” is widely used. Typically, it connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield. Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments. Correspondingly, opposite characteristics – a high ratio of price to book value, a high price-earnings ratio, a low dividend yield – are in no way inconsistent with a “value” purchase.” Source: Berkshire Hathaway 1992 Annual Report. "
He then goes on to say that in their definition "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. Period. Growth is therefore inherently part of the value judgment, not a separate discipline. If it is that simple, and it is, (at least, the definition is simple) then how has the industry got in such a muddle, and why do commentators continue to use price to book ratios, price to earnings ratios or their modern equivalents such as EV to Ebitda, as a proxy for value. We all know that it does not mean a thing. So why do we do it?"
Heuristics. We love relying on simply easy to use heuristics, which allow us to take complicated topics and use simple metrics to jump to conclusions. If you use the definition above to value a business, then these other value metrics become moot. It is intellectually lazy to base decisions on simple metrics without getting the proper information He also says that the marketing of these funds helps with the fund's survival.
- Nomad is a value investor in the sense that they like buying stocks at half price.
- They are concentrated as top ten holdings make up 65% of partnership assets
- They have made good money despite being told their fee structure is poor. But they make money on performance, not on asset gathering
Why didn't the great value investors of the 90's own the best-performing stocks of that decade? EMC, Dell, PMC Sierra, and Microsoft all did incredibly, yet none of the large growth investors held through that entire time period. "A study by Michael Goldstein at Empirical Research, a research boutique, claims that 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." I'd love to see what the numbers look like on this now, but I imagine it isn't very much different.
- "We take no comfort from the fact that not seeing success is a perennial investment mistake: in the 1950s a large Baltimore based fund management company sold their clients’ shares in IBM only for the shares to appreciate to the point that the value of the shares sold would become bigger than the whole fund management company itself. What we are trying to do today is avoid the Baltimore company’s second mistake, which was to sell an equally big stake in Wal-Mart in the 1970s!"
Nick Sleep then ask why a value or growth investor would buy or sell a specific stock? He claims 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." This is absolute gold. This is why I love finding companies that have high ROE/ROIC as they have shown the past (and hopefully the future) that when they get their hands on equity and/or debt, they can generate substantial profits for the business. If you can find a few of these and hold on, you can make a boat load of money as Sleep alludes to above.
Now we look at the business case for Costco Wholesale
- Membership keeps the business top of mind for the customer
- People shop at Costco because the price is fixed at 14% markup, it doesn't matter what the item is, that's always the markup
- Their competitive advantage is that they average supermarket has a markup that's twice as high as Costco in margin terms. Costco makes money doing this by ensuring:
1. that they keep operating costs low (cost basis is 15% of of revenues vs 25% for Walmart).
2. "That the wholesale price is as competitive as can be. 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!"
3. Economies of scale. When Costco opens a new location, they increase the amount of volume they purchase from vendors. This increased volume generally ends up leading to a lower price in all locations for a given item. This increase revenue growth and and revenue per square foot.
- Most stores are owned rather than leased. This helps keep costs low so landlords can't increase rents
- The company grows by giving more back, strengthening it's probability of long term success
Next he covers the investment case for Costco
Nick says there are a few heuristics at play keeping Wall Street from piling money into Costco:
The Company has low margins
It's expensive at 24x earnings
Costco has a cost problem
In rebuttal he says that Costco has low margins to allow for growth into the future. They have low margins on purpose, as that's part of the business model, if they raised them slightly, their competitive advantage would disappear but their income would sky rocket and the PE would drop. Costco has had increasing costs as a percentage of revenue due to expense of dwarehouses and distribution centres which are going to be utilized for the next phase of growth. Also the cost of employee benefits and insurance.
- "What characteristics could one bestow on a company that would make it the most valuable in the world? What would it look like? Such a firm would have a huge market place (offering size), high barriers to entry (offering longevity) and very low levels of capital employed (offering free cash flow). Costco has some of these attributes. The range of products is as wide as any retailer, and by passing savings back it is building a formidable moat. It is also more asset light than its peers, but it is not the lightest of them all. "
The letter then go on to discuss how a business like Ebay strike all these characteristics. The asset light nature of Ebay at this time, allowed for cheap expansion. For instance a Costco expansion store might cost $15m (with a coverage radius of ~30 miles), where as if Ebay spent $15m on servers to expand this price would be more than enough to serve entire countries.
They finish the letter discussion the relationship of value to stock prices: "We go through this analytical process with each investment and have expressed our thoughts on Costco here to help illustrate that transient stock price quotations mean little to us (except as an opportunity set for incremental capital). And they should mean little to you. Ignore Nomad’s performance so far. 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. In the last year or three, share price quotes happen to have been in our favour and they flatter your manager’s input. You should not always expect this to be the case. There is no reason why business values and share prices should move hand in glove. You should expect that there will be a time when prices, and Nomad’s performance, significantly lags the performance of our underlying businesses. It is then that we will ask you to be contrarian, and invest more."
After reading this and considering what Buffett says about how you shouldn't care one bit if the stock market closed I realize that I check my prices way too often. I removed my widget from my phone, so I will stop checking so often. What really matters to me is having the information available about my holdings to make necessary changes. Like Nick said above, "opportunity for incremental capital" meaning if prices drop down to a price I think I can get a good return on, I'll pile in some cash. But I don't need to waste time obsessively checking prices.
Lucky for me, my price checking hasn't "forced my hand" to FOMO into any stupid investments, but I'd prefer to use a strategy that suppresses this heuristic as much as possible. As Charilie Munger has said “It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.” To any rational investor FOMO is stupid, but it can be hard to resist. I feel this strategy will reduce my ability to "be stupid."