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Nick Sleep and his partner Qais Zakaria launched the Nomad Investment Partnership in 2001 and in the following 12 years would go on to return a cumulative 921% to their investors. In 2013, at the top of their game, Nick and Zak decided to unwind the partnership, leaving behind several billion for their investors, an understated legacy, and about 200 pages worth of letters to partners.
In a personal letter to Warren Buffett, an investor in Nomad and a clear influence on its investment style, Sleep said “Zak and I are keen to leave the professional industry behind, and spend our time in more caring pursuits.” They both run charities today.
After reading and reflecting on the letters, I consider Nick Sleep to be an intellectual hero of mine. Not just because of his impressive investment performance but because of the way he carried out his business, how he so obviously loved his craft and had a great time doing it, how he put his money where his mouth was, and how clearly he thought and communicated.
Through his letters, Sleep communicated what has resonated with me as the most satisfying explanation of true long-term investing. I consider his focus on the long-term “destination” for both his investments and his own firm as the cornerstone lesson. Additionally, however, I learned about why investing should be simple but not easy, exploiting behavioral psychology, making decisions, and practical lessons on running an investment partnership.
Like most investors with longevity worth studying over a whole career, Sleep’s investing style changes and grows as you read. What started as more traditional deep value eventually became a more Munger-like great business at a fair price style with a ruthless focus on the long term. For context, I believe his most powerful lesson wasn’t written until page 175 or nine years into writing his letters.
Here I will run through the learnings and quotes that I found most impactful. For more background on Nick Sleep and Nomad, I recommend William Green’s Richer, Wiser, Happier and this blog post by Frederik Gieschen.
Note: any bold text within quotes is my own emphasis, no bolding was used in the original letters
Sleep is primarily concerned with the destination, for both his investments and his own firm. He states very early on that the desired destination for the investment partnership is $16 in 20 years, meaning he wants to turn each dollar invested at inception into $16 in two decades. The bumps along the road, diversions, and drawdowns seem meaningless when you are singularly focused on a goal with that duration.
“Destination analysis is consciously central to how we analyse businesses these days. It helps us ask better questions and get to a firm’s DNA.”
“Annual results will bounce around all over the place, and for Nomad more so than more diversified funds. But does that matter if the destination is secure? Indeed, if we could turn U$1 into U$16, does it matter if it takes 18 years or 22 years?... securing the destination is much harder to do if you are trying to beat the index in annual increments at the same time.”
“To our way of thinking the question is, what good habits and techniques ensure that the destination is secure (even if the ride is bumpy), and that U$16 will be realised? This comes down to the sustainability of an investor’s comparative advantage.”
“Nassim Nicholas Taleb published an interesting paper which also linked the sequence in which returns occurred to how they made investors feel. He argued that investors often accept the risk of an occasional large loss for a steady small profit as the recurrence of the gains made them feel better. This occurred even when an opposite strategy, of steady small losses followed by a large gain, generated superior end results. Travelling comfortably dominates people’s thinking when they should be thinking about destinations.”
Closely related to a firm’s destination is the concept of deep reality. I think this is the most profound concept in Sleep’s letters. Understanding the deep reality of a company is what allows you to have confidence in the destination. Deep reality is best understood as a distillation of what determines a company’s success. It’s not the metric that drives success like same-store sales growth or return on assets. You can tell that these distillations are the product of countless hours of turning a business over in their head a thousand times and emerging with a simple (but not easy) recipe that they believe is the major determinant of long-term success.
“If we had our time again, we would hope not to be seduced by their (apparent) mathematical cheapness but weigh more heavily their DNA, if you like. One of the things we have learnt over the last few years is that our most profitable insights have come from recognizing the deep reality of some businesses, not from being more contrarian than everyone else.”
The clearest explanation of this concept is this example of “weighing information” related to Wal-Mart:
“Investors see the information (on conference calls they cheer ‘great quarter, Wal-Mart’) but, in our opinion, they incorrectly weigh the information. It could be argued that lots of things had to go right for Wal-Mart to grow for forty years. That is certainly true but, at its heart, very few simple things really mattered. In our opinion the central engine of success at Wal-Mart was a thrift orientation fueling growth with the savings shared with the customer. This is the deep reality of the business. This should have had the greatest weighting in the minds of longterm investors even if other things looked more important at the time. Instead, investors may place too much emphasis on valuation heuristics, or margin trends, or incremental growth rates in revenues or any of the list above, but these items are transitory and anecdotal in nature.”
“For example, what investors needed to understand, and attribute sufficient weight to, in order to hold Colgate-Palmolive shares for the last thirty years, and so enjoy the fifty-fold uplift in share price, was the economics of incremental products (often referred to as “line extensions”, from the first “Winterfresh” blue minty gel in 1981 to “Total Advanced Whitening” today) and the psychology of advertising. Other items were important too, discipline in capital spending in particular, and there were lots of other things that seemed important along the way (stock market crises, country crises, management crises and so on) but it was the success and economics of line extensions and advertising that, in our opinion, was what the long-term investor really needed to embrace.”
“A similar story can be told at Nike and Coca-Cola (manufacturing savings funneled into dominant advertising) or Wal-Mart and Costco (scale savings shared with the customer). Recognising and correctly weighing this information inspite of the latest news flow is a matter of discipline, and it is that discipline that is so richly rewarded in the end. 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 than the distractions of the day.”
When writing about the deep reality of Colgate-Palmolive, Sleep referred to “line extensions” as the most important thing. He also said the same about “manufacturing savings funneled into dominant advertising” for Nike and Coca-Cola, and “scale savings shares with the customer” for Costco. The deep realities that Nick and Zak understood about certain firms were expressed in “investment models” that they could recognize across industries and time. They admitted to only really understanding a few of them on this level but demonstrated that a few is all you need.
Sleep even goes as far as to divide his portfolio into the various models under which the investments were made:
“Zak and I think of the Partnership in terms of business models deployed by our investee firms. The names we use to describe these models are not that catchy but please bear with us. The largest group making up over half the Partnership are, no drum roll required, scale-economics-shared; next comes discounts-to-replacement- cost-with-pricing-power (I warned you) at around fifteen percent; hated-agencies fifteen percent; super-high-quality-thinkers just under ten percent.”
“In the office we have a white board on which we have listed the (very few) investment models that work and that we can understand. Costco is the best example we can find of one of them: scale efficiencies shared. Most companies pursue scale efficiencies, but few share them. It’s the sharing that makes the model so powerful. But in the center of the model is a paradox: the company grows through giving more back. 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? 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 longterm success.”
“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. 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.”
You can hear how much conviction this high-level construct gives him about Amazon’s destination:
“Scale economics shared works across industries too with the effect that load factors at the low-price Malaysian airline, AirAsia, are superior to high-low flag carrying airlines. And it works online: Amazon have deployed it so well that Amazon’s operating costs (per dollar of sales) plus its operating margin are less than some of its high street peers’ costs (per dollar of sales). This offers the prospect that, in theory, Amazon’s high street peers could price their products at net income breakeven and still not undercut Amazon’s prices or profitability. For these high street competitors the game is over. They will leak revenues to more efficient rivals as customers respond to the incentive of consistently low prices and convenience.”
Deep discount to replacement cost with latent pricing power:
“The model is premised upon the observation that the business needs to replace its assets and will require prices which 1. fund the capex, and 2. economically justify the spending. Either that or Zimbabwe will have to go without cement or import from abroad (tricky for this land locked country).”
These are two longer quotes, but they are worth reading in full because they set up Sleep’s explanation of long-term investing, which was the most impactful piece of his letters for me.
“How do we know we are taking a different view to the crowd? A clue can be gleaned from the period that other investors typically hold the shares of the companies in the Partnership.. other investors hold stocks in our portfolio for on average twenty weeks. We expect to own shares for around two hundred and sixty weeks! So, what is going on? It seems to us that most investors look at the accounting outputs of a company (the reported financial data) as a guide to near term price movements and play the market accordingly. As stated in the investment objective section of the Nomad prospectus our goal is to “pass custody (of your investment) over at the right price and to the right people”. That’s what investing is. Zak and I concentrate on a deeper reality: the inputs to future value moves. Our peers are trading shares at the short end of the equity yield curve where the competition is the greatest, and we are investing at the long end where competition is the least. We respond to completely different stimuli.”
“Readers of our letters (there must be some) may be familiar with the notion of the equity yield curve. (In brief, the equity yield curve is a concept that argues that patience has a value, and that returns increase with time in the equity market as they do on a normal bond market yield curve). In the bond market the higher yield is there to compensate for the increase in risk that the principal will not be repaid, or that the principal may be devalued by inflation. That is not how it works in the equity market: in our opinion business outcomes can be more predictable several years out than they are in the near term. For example, we have no idea where the market will end this year but given corporate strategies, capital allocation and starting valuations, I think we have some idea of how our companies will evolve over the next few years. In other words (at this point economics students may wish to cover their ears) the return from investing in shares can be both increased and de-risked by time.”
Sleep’s explanation of long-term investing is closely linked to the equity yield curve concept. He argues that not only is long-term investing simpler and more elegant, but it is a competitive advantage. Anticipating next quarter’s earnings and the resulting share price move is a crowded trade. Aligning yourself with firms that are focused on creating long-term value means that value will only mostly accrue to long-term owners.
Another long quote that is worth reading, as it is the crux of Sleep’s most important lesson:
“The opportunity for Nomad’s investors comes from realising to whom these firms are more valuable. Certainly not the short-term investor, who will be indifferent as to whether Amazon, Asos or Air Asia will be the most valuable retailer/fashion e-tailer/airline in the world in ten years’ time. The institutional fund manager may be similarly indifferent. This collective professional myopia presents the true long-term investor with the spoils, but the mechanism for this wealth transfer from short-term holder to long-term investor is subtle.
When investors value a business they have in their minds, consciously or not, a decision tree with the various branches leading to all possible futures and probabilities attached to those branches. The share price can be thought of as an aggregate of the probability weighted value of these branches. The problem, as Santa-Fe Institute scientist Ole Peters most recently pointed out (SFI Bulletin 2009, volume 24), is that this is not an accurate representation of what the future will be! The next step for the company will not be to visit all of those branches simultaneously. In reality the firm in question will only visit one of those branches before proceeding to the next and so on. Short-term investors spend their time trying to handicap the odds of each branch.
Guessing which-branch-next can be a crowded trade, but it’s fine, as far as it goes. However, it rather misses the big picture, in our opinion. We would propose that some businesses, once they have progressed down the first favourable branch, stand a much greater chance of progressing down the second favourable branch, and then the third, as a virtuous feedback loop builds. The process takes time, but a favourable result at any one stage increases the chances of success further down the line, as it were. Think of it as a business’ culture.
The point is that the odds associated with any of these branches are not static but, in a hugely important way, they improve as one travels from branch to branch. Imagine the payoff in a game with these attributes? If investors recognise the inevitability of these improving odds they are also usually indifferent to them, perhaps viewing the eventual greatness of a business as simply outside their time horizon. Nevertheless, the effect of this indifference on share prices is to leave long-term success undiscounted (note, share prices are an aggregate of all possible future worlds, not the actual future) and the rewards from that observation may be enormous for the patient few. We certainly expect so.”
“The trick, it seems to us, if one is to be a successful long-term investor, is to recognize the sources of enduring business success, get in early and own enough to make a difference.
Which raises two questions: what are the sources of success and second, if these are so readily recognized up front why are they not discounted in prices already?”
“The fund management industry has it that owning shares for a long time is futile as the future is unknowable and what is known is discounted. We respectfully disagree. Indeed, the evidence may suggest that investors rarely appropriately value truly great companies.”
“We do try and run Nomad with some slack in the system. In the June 2007 letter to partners we suggested that one of the benefits of a long holding period was that it allowed time for gentle contemplation”
“In our opinion we have the right environment to think things through, think rationally, and come to meaningful long-term insights. Whether our insights are economic or not will be our fault, it will not be due to the environment in which we work. Zak and I don’t want to be busy; we want to be right.”
“Once it has been created, what is to be done with the slack? The best activities might be those that refresh the mind, broaden horizons and reinforce good habits, and it is in this spirit that I have become a governor of a failed school in south east London.”
“There are, broadly, two ways to behave as an investor. First, buy something cheap in anticipation of a rise in price, sell at a profit, and repeat. Almost everybody does this to some extent. And for some fund managers it requires, depending upon the number of shares in a portfolio and the time they are held, perhaps many hundred decisions a year. Alternatively, the second way to invest is to buy shares in a great business at a reasonable price and let the business grow. This appears to require just one decision (to buy the shares) but, in reality, it requires daily decisions not to sell the shares as well! Almost no one does this, in part because it requires patience - and the locker room set does not do patience - but also because inactivity is the enemy of high fees.”
“Each day Zak and I shuffle in, swop trainers for slippers, pull up a pile of annual reports and set about analysing and re-analysing our investments. Routinely we try to kill our companies (they can be killed!), and we sift prospective investments...The research continues but, as far as purchase or sale transactions in Nomad are concerned, we are inactive. Inactive except, perhaps, for the observation, seldom made, that the decision not to do something is still an active decision; it is just that the accountants don’t capture it. We have, broadly, the businesses we want in Nomad and see little advantage to fiddling.”
“Our portfolio inaction continues and we are delighted to report that purchase and sale transactions have all but ground to a halt. Our expectation is that this is a considerable source of value added!”
“That is why, in the hands of Warren Buffett for example, one could rationally argue that cash is worth more than cash. That is not an argument for hoarding cash, as many do today. For the cash to be worth more than cash it must be invested intelligently. It is, however, an argument for a cash buffer, just in case, a little slack in the system.”
“Good investing is a minority sport, which means that in order to earn returns better than everyone else we need to be doing things different to the crowd. And one of the things the crowd is not, is patient.”
“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.”
“In the office we keep a list of companies assembled under the title “super high-quality thinkers”. This is not an easy club to join, and the list currently runs to fifteen businesses. Entry is reserved for the intellectually honest and economically rational, but that alone is not enough. There are many companies that do the right thing when their backs are against the wall, and this list excludes those temporarily attending church. The anointed few are there because they have chosen to out-think their competition and allocate capital over many years with discipline to reinforce their firm’s competitive advantage.”
“This list is a group of wonderful, honestly run compounding machines. We call this the ‘terminal portfolio’. This is where we want to go. The question is, why is this list not the same as the current Nomad portfolio?”
“The problem of course is price. In paying up for excellent businesses today, investors are already paying for many years growth to come, in the hope that, as the saying goes, ‘time is the friend of a good business’.”
“Several studies and casual observation reveal that individual prices oscillate widely around a central price year in year out, and for no apparent reason. Certainly, business values don’t do this. Over time, this offers the prospect that any business, indeed all businesses, will be meaningfully mispriced.”
“What is the probability that say, over the next ten years, a good portion of these ‘super high-quality thinkers’ will be priced at 50c? Our betting is that the odds are reasonable. Even though prices are generally high, the trick is to do the work today, so that we are ready.”
“we make people sign a form saying they understand that the fund is not suitable for those with time frames less than five years. No one else does that. We make them do it by the way, to try and put the investment in a different psychic space than other savings they may have. And to avoid the pressures of social proof and jealousy/envy I mentioned earlier”
“When we find a pool of good ideas of reasonable size, we will be in touch. However, we will not open just because Nomad will be independent or due to some dreadful manifestation of the principal agent conflict. The cost-reimbursement management fee means we do not need to open to put bread on the table. To date, we have turned U$1 into around U$2.70. Our aim is to turn this onto U$10 within a decade (approximately fifteen percent compound per annum) and we are somewhat indifferent as to how much money we carry with us during the process: For Zak and I, it is all about the destination.”
“Zak and I are not envious of index returns and we encourage you not to be either. We see our goal as far more personal than that. Our goal is a track record to be proud of, we wish to accomplish something meaningful, and to do that we aim to earn returns, over time, on par with those investors we greatly admire (Ruane, Tweedy, Klarman, Whitman, Hawkins, Miller, Schloss, Berkowitz). In no way do we guarantee returns, but if we can approach their results then, over time, we will beat the index too.”
“The debate over growth and value is perennial, and quite unnecessary... so that we all understand, our definition is that 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.”
“Nomad is a value investor in the sense that we like to buy stocks at half price. But the largest holdings would be described by most of our peers as growth stocks.”
“Zak and I run a single partnership that has long-term investments in the shares of, for all that matters, ten companies, all paid for with cash. We own the investment advisor that manages the partnership and, ordinarily, we are closed to incremental subscriptions and so free of marketing obligations. That’s it. It is terribly, terribly simple, but it is not easy. It is not easy because there are so many distractions: news items, the soap opera of the stock market, macroeconomic events, politics, currencies, interest rates, principal/agent temptations, regulation, compliance, administration and so on - this list is not exhaustive! It is all too easy to make things more complicated than they need to be or, to invert, it is not easy to maintain discipline.”
“What we are doing is investing at its most honest and most simple. But it is not easy.”
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