Investing lessons from ‘one of the greatest investors I’ve ever come across’

 

Nick Sleep is one of the greatest investors I’ve ever come across – writes The Undercover Fund Manager.

 

Sleep managed the Nomad Investment Partnership for over a decade, along with his partner Qais Zakaria, delivering returns of 921% versus 117% for the MSCI World Index (September 2001 to December 2013).

He has tended to keep a low profile so isn’t as well known as some of the other great investors. That said, he’s started to gain more recognition recently following the publication of the Nomad Investment Partnership letters.

I had the privilege of reading these 245 pages of investing wisdom over the Christmas period and have picked out 35 extracts, organised into 10 key themes. This blog only touches the surface. For a fuller appreciation of this remarkable investor I’d encourage you to read the complete letters.
 

Nick Sleep on weighing information

 
“Information, like food, has a sell-by date; after all, next quarter’s earnings are worthless after next quarter. And it is for this reason that the information that Zak and I weigh most heavily in thinking about a firm is that which has the longest shelf life.”

“Investors tend to latch on to what can be measured, aided by the accountants and to some extent by their own laziness. But there is a wealth of information in items expensed by accountants, such as advertising, marketing and research and development, or in items auditors ignore entirely such as product integrity, product life cycles, market share and management character.”
 

On the value of patience and long-term thinking

 

“The trick to being a good investor, over the long term, is to maintain your long-term oriented discipline.”

“Active fund managers have to look active. One way to do this is to sell Wal-Mart, which appeared expensive (but actually wasn’t), to buy something that appeared cheaper (but, er, also wasn’t); investors are not long-term and did not look further than the next few years or, more recently, few quarters. Evidence for this can be gleaned from the average holding period for shares, which stands at just a few months; fund managers wish to keep their jobs and espousing a ten-year view on a firm risks being a hostage to fortune; marketing folks require new stories to tell and new stocks in the portfolio provide new stories; fund managers sell their winners in order to appear diversified in the eyes of their clients.”

“We can all do momentum investing, but it is emotional investing and I just don’t think it is that intelligent, or profitable.”

“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.”
 

Our most profitable insights have come from recognising the deep reality of some businesses, not from being more contrarian than everyone else

 
“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.”

“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.”
 

On business quality versus valuation

 
“There is a dark corner of the portfolio, single-digit in percentage terms, where the economic reality is troubling… If we had our time again, we would hope not to be seduced by their (apparent) mathematical cheapness but weigh more heavily their DNA.”

“One of the things we have learned over the last few years is that our most profitable insights have come from recognising the deep reality of some businesses, not from being more contrarian than everyone else.”

“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.”

“Factors such as culture, because they are hard to quantify, often go undervalued by investors; investors presume regression to the mean starts at the time of their analysis or, as CFA students may recognize, in year three or five of a DCF analysis!”

“Conventional thinking has it that good things do not last, and indeed, on average that’s right… Investors know that in time average companies fail, and so stocks are discounted for that risk. However, this discount is applied to all stocks even those that, in the end, do not fail. The shares of great companies can therefore be cheap, in some cases, for decades.”

“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.”
 

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

 
“When we think about companies, the overriding 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 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.”

On doing nothing and creating the right environment

“We find many great businesses available at what seem sensible prices, but, in our opinion, they do not compare favourably with what we already own, and so we move on, constantly comparing what we have with the alternatives, but often, as far as the portfolio is concerned, doing nothing.”

“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.”
 

On what makes a great business great

 
“Firms that have a process to do many things a little better than their rivals may be less risky than firms that do one thing right, because their future success is more predictable. They are simply harder to beat.”

“Zak and I would guestimate that fewer than five percent of publicly listed firms do what they think is right, rather than what they think plays well with the outside world (media, Wall Street, investors).”

“We have learned, or rather come to appreciate, that the character of a firm – call it the ability to resist locker room temptation – is far more important than first we realised. This is an important insight. In the long run it may be all that matters.”
 

The character of a firm – the ability to resist locker room temptation – is far more important than we realised. In the long run it may be all that matters

 
“Nomad’s investments may be in publicly listed firms but these firms are also overwhelmingly run by proprietors who think and behave as if they ran private firms.”

“There are very few business models where growth begets growth. Scale economics turns size into an asset. Companies that follow this path are at a huge advantage compared with those, for example, that suffer from Barbie syndrome. Put simply: average companies do not do scale economics shared. Average companies do not have a healthy culture. After all, average companies are more like GM than Wal-Mart!”

“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.”
 

On the perils of over-diversifying

 
“The church of diversification, in whose pews the professional fund management industry sits, proposes many holdings. They do this not because managers have so many insights, but so few! Diversity, in this context, is seen as insurance against any one idea being wrong. Like Darwin, we find ourselves disagreeing with the theocracy. We would propose that if knowledge is a source of value added, and few things can be known for sure, then it logically follows that owning more stocks does not lower risk but raises it!”

“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. At Nomad we would rather results were more volatile year to year, but maximized our rolling five-year outcome.”
 

On learning from mistakes

 
“There is a philosophical argument that a mistake is only a mistake if you call it so, otherwise it is a learning opportunity. That seems like the right spirit to us. Our two biggest analytical mistakes (sorry, learning opportunities) to date were probably Conseco and Stagecoach.”

“The analytical mistake in both cases was to have a static view of a firm formed at the time of purchase, which failed to evolve as the facts changed. This error was reinforced by misjudgments such as denial (the facts had changed) and ego (we can’t be wrong). There was also an over-reliance on price-to-value ratio type analysis, which can encourage a tighter range of outcomes than occurs in reality.”
 

The biggest error an investor can make is the sale of a Wal-Mart or a Microsoft in the early stages of the company’s growth

 

“A large proportion of Nomad’s performance in 2007 came from the lessons learned from mistakes in 2003 and 2004. Think of it as a return on prior year losses.”

“The biggest error an investor can make is the sale of a Wal-Mart or a Microsoft in the early stages of the company’s growth. Mathematically this error is far greater than the equivalent sum invested in a firm that goes bankrupt. The industry tends to gloss over this fact, perhaps because opportunity costs go unrecorded in performance records.”
 

On ignoring the index

 
“Zak and I spend no time at all thinking about the index (indeed we were unaware of the index return until I set about writing this letter).”

“Once the index is seen as risk-free the mistakes that follow cascade and include: requirement to have an opinion on everything inside the index regardless of one’s circle of competence, an unwillingness to invest in other, better opportunities, and overdiversification. These three mistakes destroy a lot of capital.”
 

On sources of ‘edge’

 

“There are three competitive advantages in investing: informational (I know a meaningful fact nobody else does); analytical (I have cut up the public information to arrive at a superior conclusion); and psychological (that is to say, behavioural)… the enduring advantages are mainly psychological.”
 

On process versus outcome

 

“Good investment process is not apparent in one quarter’s worth of transient stock price quotations, or one year for that matter!”

“The ‘Pavlovian’ association of poor short-term results with long-term incompetence and confusion between the two can lead to disastrous decisions.”
 
This article was originally published at theundercoverfundmanager.com and is republished with permission.
 

Click to visit our friends at: