Personal Finance
My favourite lessons from Nick Sleep's famous investing letters
The Nomad Partnership letters are often put up there alongside those written by Warren Buffett. Here were my three big takeaways.
My favourite set of investor letters are the ones that Nick Sleep and Qais Zakaria sent to investors in Nomad, the fund they managed together until 2014. I read the letters again recently and thought I’d share three of my biggest takeaways.
In case you are curious, the full Nomad letters can be found on the website of Sleep’s I.G.Y Foundation. I would highly recommend reading the full collection if you are interested in long-term investing and business ownership.
Here were the three things I found most interesting this time around.
Takeaway 1: Focus on the business destination
“When we think of our investee companies, the firms which we would quite happily own with no word from them for years are those businesses in which we have the highest confidence of reaching a favourable destination: they are the firms we think we know will work.”
Sleep and Zakaria weren’t always ‘buy and hold’ investors but they took to it pretty quickly. When you are truly a buy and hold investor, the only thing that matters is what happens to a company’s share price in the very far out future. Not what happens today, this month, this quarter or even this year.
In the short-term, stock prices wiggle around for a lot of reasons we can’t possibly predict. The longer time rumbles on, the more likely it is that the stock price will be driven primarily by the performance of the underlying business. What, then, decides the long-term direction and performance of a business?
Two things likely to feature prominently in that assessment are 1) the outlook of the company’s most important industries and 2) the company’s position within that industry.
Predicting either of those things is usually very hard. Especially in industries where technology or consumer tastes change quickly. And especially when – as a buy and hold investor – you are presumably trying to forecast this a long way into the future.
As a result, it can pay to take the same approach as Jeff Bezos and consider what isn’t likely to change much in the future.
Bezos famously pointed out that consumers are unlikely to ever start wanting higher prices, less choice and slower delivery. Therefore, a company – like Amazon – that offers the lowest prices, biggest product range and fastest delivery should do well. Especially if it has advantages that allow it to do those things to a degree that others cannot.
I brought up Amazon (NAS: AMZN) because it was famously one of Nomad's biggest holdings. And thinking about the two basis factors I mentioned before – industry growth outlook and competitive position – goes some way to explaining why Sleep and Zakaria were so confident about the “destination” of Amazon’s e-commerce business.
- The industry’s growth outlook couldn’t have looked much better. E-commerce was proven but it was still at an early stage of taking wallet share from traditional retail. There was clearly a long runway for more shopping to shift online over time.
- Amazon had an incredibly strong competitive position. Today our analyst Dan Romanoff thinks that Amazon’s ecommerce marketplace has a Wide Moat thanks to several factors including cost advantages, network effects and its strong brand. Amazon was already benefitting from some of these dynamics at the time of Nomad's investment, giving it a strong market position.
There was more to it than that, though. Sleep and Zakaria took the idea of scale-based cost advantages a step further by popularising the idea of “scale benefits shared”. For many, this is their biggest contribution to the school of business analysis and investing.
Takeaway 2: The power of scale benefits shared
“The simple deep reality for many of our firms is the virtuous spiral established when companies keep costs down, margins low and in doing so share their growing scale with their customers. In the long run this will be more important in determining the destination for our firms that the distractions of the day.”
By the end of their career, Sleep and Zakaria’s fund was invested almost solely in companies that aligned with their “scale benefits shared” mental model. Their investment in Costco (NAS: COST) exemplified this approach to understanding a company’s source of competitive advantage.
As you may know, Costco is religious about keeping its retailing prices and profit margins as low as possible. This means that Costco’s huge bargaining power with suppliers benefits customers far more than it fattens the company’s retailing profits – the very definition of scale benefits shared.
Competitors can’t afford to compete with Costco on price. After all, there is essentially no profit margin to undercut. Given Sleep and Zakaria’s focus on a company’s long term destination, you can see why they loved companies with this business model. When competing with a company is this hard, it is easier to be confident that the company will still be thriving.
Trying to think of more companies in this mould is hard, and that’s because there aren’t many of them.
As Sleep explained in one letter, “we often ask companies what they would do with windfall profits, and most spend it on something or other, or return the cash to shareholders. Almost no one replies give it back to customers – how would that go down with Wall Street?”
Few management teams in that situation would be able to resist delighting markets with a higher reported profit for the year. Sleep continues: “That is why competing with Costco is so hard to do. The firm is not interested in today’s static assessment of performance. It is managing the business as if to raise the probability of long-term success.”
If you do stumble across a business in this mould, it may be worthy of a closer look. Especially if you are looking for investments you can hold for a long time.
Takeaway 3: The importance of forgiveness
“If the market was rational and the company an organisation that learns, then the stock price should rise after a mistake. But this is seldom the way the world works. It is as if investors presume that companies do not learn from their mistakes.”
The first two takeaways I’ve covered in this article are quoted widely by people who have read Sleep and Zakaria’s letters. I might be wrong, but I haven’t seen this next one mentioned nearly as much.
That’s a shame, because I think the idea of being able to forgive companies for their errors is quite powerful. Let me explain through an example that is currently playing out.
Fever-Tree (LON: FEVR) sells premium tonic water, mixers and sodas. I can heartily recommend the grapefruit soda for a summer sip.
Anyway, Fever-Tree’s profits grew like a weed between 2015 and 2021 as its premium tonic waters uprooted Schweppes in the UK. That was until the spike in European gas prices smashed Fever-Tree’s profits.
Glass bottles were one of Fever-Tree's biggest input costs, and they hadn’t energy hedged their supply contracts. The company's revenues continued to grow but the bottom line took a beating that Fever-Tree is still in the process of recovering from.
One reaction here might be to blame management for not seeing this risk beforehand. Or to view Fever-Tree’s business as being more fragile than it was before this happened. Sleep’s insight made me wonder if that would be wise.
If Fever-Tree has learned from this episode and taken steps to ensure it is not repeated, couldn't that make the business and its supply chain more robust going forward? This isn't me saying the shares are cheap – they aren't in our coverage at the moment. But the Nomad letters allowed me to see this issue from a new angle.
The 'New Coke' fiasco offers another example. In 1985, Coke (NYS: KO) announced a change to the formula of their eponymous cola. ‘New Coke’ wasn't just an immense flop. It led to an outcry from consumers and concern among investors that Coke may have managed to ruin one of the best businesses of all time. Coke learned fast, and the ‘Old Coke’ was brought back to market after just 79 days.
Funnily enough, Warren Buffett started buying his now famous investment in Coke in 1988, not long after it back-tracked on another potential mistake. This time, it spun off and ultimately sold the movie studio it had bought in an attempt to diversify (or as Peter Lynch might say, "diworsify") its business away from soft drinks.
I am not saying that investors should cast aside any and every mistake made by a company. Of course they shouldn’t. But if there is evidence that management have learned from the mistake, being able to show forgiveness could unearth some interesting opportunities.
After all, shares in high quality companies rarely trade at cheap prices. And having the guts to buy them when they are beaten down usually requires some kind of variant perception. Could a justified willingness to forgive provide you with one?
If you already own the shares, hanging on after a mistake may also pay off handsomely. For one, market sentiment will most likely be at its worst and most overblown immediately after the mistake becomes public. Sellers are almost guaranteed to receive a price that reflects that. So why sell into a buyer’s market?
A different kind of destination
I started this article by talking about how Sleep and Zakaria’s buy and hold strategy led to a focus on business destinations. Sleep and Zakaria were also focused on a very different kind of destination – the ‘dream scenario’ or long-term shareholder return they were gunning for.
Time and time again in the letters, you see Sleep refer to the idea of turning every £1 invested into the fund at its outset into £16. In the end, they never got there.
This wasn’t because they didn’t have the returns to make it – with a 900%+ return by the time they stopped in 2014, the duo were well on track. Rather, it was because both men retired from managing money aged 45 and started charities instead. Bravo.