Interim and Annual Letters From 2005.
It's a general characteristic of human thought to focus on near-term gains over long-term gains. The cartoon below is a great description of this quality. We are generally drawn towards crowds and will therefore display sheep-like behavior by default. Fighting this is key to being a good long-term investor.
Nick goes on to discuss Bill Millers three competitive advantages that Bill discussed at Columbia Business School:
Informationational. "I know a meaningful fact nobody else does."
Analytical. "I have cut up the public information to arrive at a superior conclusion."
Psychological. "That is to say, behaviours."
The competitive advantage that Nomad (and what I try to emulate) have over the competition is a focus on 2 and 3. Informational advantages will occur if you plan on cheating your way up, something I have no interest in. When you see insider trading, this is clearly an informational advantage. By reading, learning, and understanding things at a high level, your analytical advantage can give you an edge. On the psychological front, being long-term oriented will help prevent you from making money-losing decisions.
Nick continues to discuss limiting risk as a competitive advantage "To repeat: “what you are trying to do as an investor is exploit the fact that fewer things will happen than can happen”. That is exactly what we are trying to do. We spend a considerable portion of our waking hours thinking about how company behaviour can make the future more predictable and lower the risk of investment." This goes hand in hand with thinking in terms of probability, another major impediment to human judgment.
There are no investments where the chance of you losing money is 0. But if the chances of going to 0 are <1%, and there is a significant upside on the remaining 99%, then you might be onto an asymmetric bet that you want to make. The simplest way to do this is to make a bear case, base case, and best case, then average them out.
Nick makes a point on Costco and other investments that's very interesting "Costco’s obsession with sharing scale benefits with the customer makes that company’s future much more predictable and less risky than the average business and that is why it is our largest holding. Our smaller holdings are less predictable but in certain circumstances could do much better as investments." You can see how this fits into position sizing. Your lowest risk bets should make up the bulk of your portfolio, leaving riskier but potentially higher-paying bets at a lower percentage of your overall portfolio.
Let's briefly discuss 2 models that were heavily used in investment decisions during this time period:
Scale efficiencies shared.
Deep discount to the replacement cost with latent pricing power.
I think number 1 will be described in more detail in the future. so let's look a little bit more at number 2. Nick uses the example of a cement producer they owned in Zimbabwe. "The firm has no debt and business conditions are awful (general inflation exceeds cement price inflation and product demand is low) but the company is priced on the Harare stock exchange at one seventieth (1/70th!) of its replacement cost."
The example above was made when cement could be bought at U$20 per ton (in 1998) and in 2005 was U$180 per tonne. So any company that would've wanted to compete with them would've had a very expensive entry into the marketplace to take them on. This allowed the company to flourish and close the price to valuation gap.
2005 annual has a great opening statement:
"Our starting point has been more fortunate.
In our opinion, there have been two outstanding periods to make investments in the last ten years: Asia, in the aftermath of the Asian crisis, and during the US junk bond crisis which immediately followed the Partnership’s launch."
This is something I've been thinking about a lot lately. How many investors are successful, not just because they entered at the right time, but they ride the tailwinds and take advantage of good prices offered to them after a large event gives the opportunity. If you don't capitalize on the mistakes the market makes, then you will get mediocre returns. If you are willing to back up the truck when everyone else is selling... That's how you outperform.
Nick then goes on to discuss how re-organizing the funds' performance in descending or ascending order would psychologically make you feel different about the results. In reality, the end result is the same, but because of the availability heuristic, we place a premium on the most accessible information, which in this case is the numbers that occurred most recently.
Let's get into some of the main psychologically causes of investor mis-judgment according to Sleep and Zakaria:
Social Proof/Group Psychology; availability bias; inability to think probabilistically; lack of patience. I'm not going to cover this as you can just check out Mungers Psychology of Human Misjudgement video/talk where he covers all of these in detail (other than probabilistic thinking and patience, but you probably understand those well.)
Then he goes on to give an example of a Thai Newspaper they owned where investor psychology suffered from all the tendencies listed above: "There had been no analytical mistake, we had all done quite well with our Matichon holdings, and yet as the stock had become increasingly illiquid (in part because we all owned so much of the company) one of our fellow shareholders confessed to us that there was a business pressure to sell, and it was for this reason they had called us. Just look at the psychological mistakes these institutions may be making, their thinking would appear to be as follows: the stock has risen in price so it is OK to sell (vivid evidence), our peers want to sell (social proof), therefore it must be OK for us to sell too (group psychology), there is a business reason to sell (principal agent conflict), the shares are illiquid (vivid evidence), we do not want to get stuck in an illiquid holding (impatience, more principal agent conflict, and poor probability based thinking – highly priced shares are rarely illiquid!)."