Chit Chat Stocks - Nick Sleep: How The Secretive Investor Crushed The Market With Concentrated Compounders

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Starting point is 00:00:38 where you can earn a rebate on every contract traded. That's public.com. This is paid for by public investing. Options are not suitable for all investors, carry significant risk. Full disclosures are in the podcast description. Welcome to Chitchat Stocks. On this show, hosts Ryan Henderson and Brett Schaefer analyze businesses and riff on the world of investing. As a quick reminder, Chitchat Stocks is a CCM Media Group podcast. Anything discussed on Chitchat Stocks by Ryan, Brett, or any other podcast guest is not formal advice or recommendation. Now, please enjoy this episode. All right. Welcome in, everyone. This is the Chit Chat Stocks podcast. This is our Wednesday

Starting point is 00:01:30 episode where we study stocks, investors, really anything that we want to get better at when building our own portfolios and learning about the financial markets. This episode is one of our monthly, maybe every one to two months, we do a case study into a top investor of the last, you know, it could have been even a long time ago. We might even do Ben Graham one day, but it's usually a lot of modern investors, people who've had success in modern markets and what we can learn from. And today we are talking about the Nomad Investment Partnership, specifically a lot of the writings from Nick Sleep, one of the partners there.

Starting point is 00:02:11 And we're going to get right into it. We're going to cover what the Nomad Partnership was, their returns, some of their best investments, some of their investment philosophy, what we can learn from them, and some of our favorite parts from their 200-page letter, they call it their magnum opus, that they posted online. Ryan, you're my co-host today, as always. Are you excited to talk Nick's sleep and scaled economies shared in Costco and mongerisms? Yes, all of the above. I am excited for this.

Starting point is 00:02:42 The investor episodes that we've done before where we study some of the best investors, I've really enjoyed these. And it seems like listeners have really enjoyed these as well. And with scale economy shared specifically, we're going to get into what that is and kind of – I think he coined the term. I don't know if anyone said it before him, but it's something we've talked about a lot. So to get really the direct words right from Nick Sleep, we can finally maybe discuss what that is. So later on when we refer to it, people will have a better idea. But let's kick things off with just lay the foundation here.

Starting point is 00:03:22 Who is Nick Sleep? Why do people study him today? And let's go through some of his returns. Okay, so the Nomad Partnership was an investment fund started in September 2001 and wildly enough, was started on September 10th. So that's a pretty crazy start date. Yeah, one day before 9-11. It was originally run as a subsidiary of Marathon Asset Management, who is a large asset manager firm where the two portfolio managers work. But then it was spun out as its own fund, I think a few years into it. I'm not sure exactly how that worked, but they talked about that

Starting point is 00:03:58 through the letters. And for anyone who wants the letters, we'll put them in the show notes or on the sub stack we'll have a lot of notes on that as well the fund was run by the aforementioned nick sleep and then a guy named i don't know if i can pronounce his first name correctly but it's q a i s and then yeah and then his last name is zachariah he goes by zach for short i think for the english speakers out there and they were both very private still are very private they don't do much communication with the media, if at all. And honestly, Zach is even more private because almost all of the letters and all the communications, 200 pages worth, are from Sleep. Although it's not really clear exactly what are his ideas versus Zachariah's ideas versus both

Starting point is 00:04:45 of theirs. So I think I'm going to call it a combination of them. We're going to talk about Nick's Sleep. I'm sure it's going to be in the title of this podcast, but it really was. We don't want to do a disservice to the partnership here. And they basically ran it for 14 years. So people began to study the partnership when I think a few years ago, I think it was during the pandemic, bootleg files of their investor letters were uploaded online. They are well written and they indicated great performance through turbulent market periods. I mean, you start right before 9-11 and then you go through 2014. There's a lot of turmoil to get through. The fund generated around 20% returns for investors and likely would have put up 20%

Starting point is 00:05:25 returns for 20 years through an update estimated back in 2021. However, due to the outperformance of the three majority holdings at the time of the fund's closure, which were, and we'll get into this, Costco, Amazon, and Berkshire Hathaway, although we're not really going to talk Berkshire Hathaway since that one's talked about. Everyone knows that company so well. It is likely that the 20% IRR has been bumped up even higher. And maybe a question we could talk about is whether, given the multiple expansion at costco and how you know they were so early on this one whether he would be selling it today because that never sell strategy is getting put quite to the test with that one but that's besides the point i think the returns would be maybe 22 23 even higher

Starting point is 00:06:10 because we know that they when they closed down the fund 10 years ago they advocated everyone to just hold these companies never sell them unless things get absolutely extreme yeah i mean i kind of like situations like this where it's an investor who tried as hard as he can to stay private this is just something he's been passionate about both of them very passionate about investing and they were almost forced to have a little publicity here because people were leaking their letters to the public and these people really are private nick sleep you can find basically one picture online of him and i'm not 100 sure that that's actually him uh and then you cannot find online yeah i'll say one more source which luckily uh for the richer wiser happier book which who

Starting point is 00:07:00 wrote that his last name is green it's a good book i have it downloaded he actually did a chapter on And then he had the fortunate time to talk to them, I believe, back a little bit before the pandemic, maybe even during the pandemic a couple of years ago with actually going to their office in the United Kingdom and spending a few hours discussing their philosophy, getting updates and all that good stuff. And there's about 30 pages in that book if people want to check that out as well. But for more on the performance, I should say that it was 20.8% performance before fees, and then after performance fees is 18.4%. And that 20.8% compares to 6.5% annualized for the world index. It's fair to use that, I think, but we'll get into why they don't even care about the index and why that's not even something that they're measured on. It's just something they had back with Marathon Asset Management. And it's a good comparison for

Starting point is 00:07:58 some of their investors that like that type of stuff. So investors, including ourselves, which is why we're doing this podcast, are fascinated with Nomad's transition from cigar butt international investing, which was the majority of investing the first few years, to a permanent, quote unquote, never sell investing, which is why and how they ended the fund. It also helps that they put up great returns at a decent scale. If we want any more notes, they made around $2 billion total for its clients. And then I guess, you know, they decided to close up shop in 2014 after a pretty good run. And they may have gotten bored of doing it as a public, you know, if they weren't making any trades per year, as we'll get into, and they had

Starting point is 00:08:43 their core holdings that they couldn't find anything to replace with, they probably thought, well, we don't need to be charging fees for this. We're going to tell our clients that we're going to keep doing this. You can hold the stocks as well, but we're going to give back all the money. So why do they invest the way they do? How did they beat the market over the long term? What did they see in some of these companies like Costco and Amazon? Ryan, we're going to get into it. So let's first talk about some of their investments. Do you want to talk about Costco? Sure. I think that's probably the one they get the most notoriety for these days is the Costco investment just because they've written so much about them and they describe the competitive

Starting point is 00:09:21 advantages in such an understandable way. The other thing I'll add real quick, the author of Richer, Wiser, Happier is William Green. That's his full name. So feel free to look up that book if you want. But let's talk Costco. To give the layout here for the rest of the discussion, We're going to go through some of their most notable investments, some of the frameworks that they use that investors, all investors can really apply. And then we'll talk through maybe our favorite parts about the letters and just our overall thoughts on Nick's sleep. But let's start with Costco. So they write a number of times about Costco throughout their letters, and they do a really good job describing the business model in general. but I'm not going to go through that because everyone kind of knows the Costco business model

Starting point is 00:10:14 at this point. For those that don't, real quick, they offer really low prices. They don't mark up their goods by nearly as much as a lot of grocers. They really, to their core, offer everyday low prices. It's led to consistent growth because people know what they get with the Costco membership and so people are willing to pay for it. But he does a very good job summarizing the power that this business model has in one part of the letter. So I'll go through this quote real quick. He says, in the case of Costco, scale efficiency gains are passed back to the consumer in order to drive further revenue growth. That way, customers at one of the first Costco stores outside Seattle benefit from the firm's expansion into, say, Ohio, as they also gain from the

Starting point is 00:11:02 decline in supplier prices this keeps the old stores growing too that point the point is that having shared the cost savings the customer reciprocates with the result that revenues per foot of retailing space at costco exceed that at the next highest rival walmart or sam's club by about 50 so i guess i can kind of maybe summarize that a little more because they are getting i'm trying to explain this the right way here so the customers at the costco store having that fixed asset or the fixed costs spread across a number of stores can lower the cost for everyone so the expansion is of their store base actually helps lower prices or maybe not necessarily lower prices nominally but raise the savings that everyone gets across the country so yeah that

Starting point is 00:12:00 That makes sense. And I think what's interesting is this is the first time I saw this, and maybe it's just because I haven't studied Costco as in depth as someone that owns the stock. But I thought what was interesting is they had a strict policy of only a 14% markup, which I believe would be a 14% gross margin from all their cost of goods sold. And it was like, no matter what we got, if it's a jar of peanut butter versus a complex little car camping system They sell for $1,000. We're going to have a 14% market versus our suppliers. That's our rule. That's all we're going to budge on there. And they're going to keep that as they scale and then they get better negotiations with their suppliers and all that stuff with the corporate overhead. They'll earn a little bit more in profits, but they're going to maintain and not see that much in operating leverage because they're going to keep that 14% market when in reality, especially in 2024, as we sit here today, they could definitely negotiate a much better market. and with their suppliers that so many people are hammering, you know, clamoring to get into their stores.

Starting point is 00:13:01 Yeah, and there's actually this interesting quote that they steal from Jim Senegal. I'm not sure where they found it. I'm looking for it right now throughout the letters. But basically, if I'm remembering this correctly, one of the sourcing agents, I can't remember their exact title, So they had these, I think it was like a pair of jeans that was selling really well.

Starting point is 00:13:28 And the suppliers actually brought down the price. And the jeans were still selling well, but the sourcing agent was like, look, they're selling well, but we just got lower rates from the suppliers. We can keep this price the same. It's not going to make a difference. And Jim Senegal said, no, if I let you do it this time, you're going to do it again. we keep ours at a 14% markup. So they actually lowered the price of the jeans that were already there. So really pretty incredible on their part. And it just kind of shows you how stringent they

Starting point is 00:14:04 were on sort of their principles as a company. Now, the other thing here, because we've talked ad nauseum about the competitive advantages of Costco, and it is important to look at because some of the economies of scale that Nick Sleep talks about throughout his letters can be applied to other businesses as well. So I think it's important to study, but I want to talk more about how they overcame some of the concerns around valuation because they were not the first ones to discover that Costco was a good business. In fact, when they first started buying, it was trading at 25 times earnings. So I don't know, if I'm looking at business that's 25 times earnings, I'm not saying that's crazy cheap.

Starting point is 00:14:53 Especially a slow grower, yeah. Yeah, and you could probably make the case that – I'm sure there were a lot of people that made the case at the time that Costco was expensive. But they kind of had this unique way of rationalizing the valuation. So he – in one of his letters, he goes through three common bear points essentially about why Costco might not be able to fulfill its valuation. He says – or something that's wrong with Costco I guess. And he says, heuristic number two, it's expensive at 24 times earnings. He says, really? Net income is a small residual as discussed above.

Starting point is 00:15:32 the firm could earn Walmart margins by taking price up a little, in which case the firm would be on 11 times earnings. But would it be a better business as a result? We think not, comma, if it allowed the competition to catch up. So this is, and we're going to talk about this principle here in some of the frameworks that he used, but they could have been more profitable if they wanted to. The earnings was because they were deferring. The earnings multiple was a byproduct of them deferring earnings today in exchange for higher customer traffic at their stores. And I just thought it was a really kind of a unique way to rationalize the valuation. And obviously that's really worked out for them. Yeah. And remember, this is in the early 2000s.

Starting point is 00:16:20 So Costco is not as a mature business as it is today. But I want to pull up the margins here on Finjet because if we look at that progress here, let me try to get the annual one. So we go back to 2014 their operating margin has climbed and you know it's climbed from like a one and a half to two percent level to about three and a half percent over the last 12 months and the thing is they did that over multiple decades and you should think okay well three and a half percent margin that's still quite low but when you double that from a lower level that can double double your your earnings power and they're still giving an incredible value to their customers and there's another part of this that i thought was interesting so

Starting point is 00:17:02 and this can really be applied to businesses of all sorts but they talk about the fact that there's a at the time it was a 45 annual membership for costco and something that they mentioned was customers are going to come back to you more if they already pay They feel like they have to come back. And the same thing applies for businesses all over. Like, here's a good example. Finchat. There are times where I would think, oh, if we just give this to someone for free and, you know, he's got all the distribution and we could just, you know, it would be great marketing.

Starting point is 00:17:49 but if you have people pay for the product it's more valuable to them they're going to use it more the they are more inclined to put in the work to actually use your product and then so we've kind of experienced this firsthand you see it with the costco membership all the time which is look i pay 45 bucks a year i'm going to go to costco because or else that money isn't worth it And fortunately, in this case, you're also getting discounts relative to where other places that you would go. But it's almost like it doesn't make sense, but it's what people do. Because you're just spending more money, even though you've already spent the money up front. It's kind of a sunk cost, but in customers' heads, it means they – it kind of locks them in. Yeah. And let's move on to a company that potentially has improved on the scaled economy share, at least in their e-commerce segment, which is Amazon. The Amazon investment was made later for the Nomad Investment Partnership. And I think it was a lesson in replicating the

Starting point is 00:18:55 scaled economy shared idea for Costco. And it's a good lesson for, I think, all investors that are listening to this. When you see an idea that you understand for them, it was the Costco business model. If you try to hunt for that in other businesses and try to identify that, that sort of pattern matching can be helpful because you've understood Costco. You can maybe understand this other business model, what people are missing. And they saw that Amazon was trying to keep prices low and create that retail subscription flywheel for e-commerce back in 2006. And I believe that is right around the time when they launched Amazon Prime, which was inspired by Costco. It ended up being one of the largest investments in the fund.

Starting point is 00:19:31 actually, I think it was the largest investment by far, given how well it performed through the end. Sleep recommended investors to keep holding this one as it was one of the three majority holdings at the time of closure. And in his personal account, it ended up being a huge position. However, back in 2021, I believe you can see this in the Richer, Wiser, Happier book for all the details. He decided to sell some of his Amazon, trim it back a little bit. Why? because it was getting so large into the, I think, closing in on $2 trillion market cap that he was worried about the valuation. Obviously, we're seeing this with a lot of companies today. People are worried about Apple, Microsoft, Nvidia, Google, how large they can

Starting point is 00:20:14 actually get, which when we talk about his idea of having patience and never selling, it's never selling to a point. There always has to be a limit here. You're not going to buy a slow grower at a hundred times earnings, you're not going to buy a mega cap company that is such a large percentage of GDP at 50 times earnings or 50 times forward earnings, whatever you want to call it. I will ask though, was he also maybe worried about a change in culture at the company over the last decade? Because when I look at his letters, and we're not going to do a whole investigation on this because we've got a lot to cover on this episode, but he has some quotes that I think don't necessarily describe Amazon today,

Starting point is 00:20:55 but that he attributed to them 10 to 15 years ago. Here's one where he says, quote, complexity is one of the main reasons firms fail as they try to grow. Wouldn't Amazon, isn't Amazon an extremely complex and getting into so many different things today? I think you would be worried about that. And here's another question.

Starting point is 00:21:15 Have they strayed from the scaled economy share? I know they're still doing it to a point, But I worry that they, I don't know, if I was him, it's not as pure scale economy shared anymore compared to Costco, even though they provide such an incredible value proposition. It's a little bit more mixed today, if you understand what I'm saying. Yeah, I could agree there. Now, keep in mind, this is, he's talking about the characteristics that are required to go from a small company to a big company. Right. At different stages of a company's life cycle, they might not need to give back as much to customers as they did in the past.

Starting point is 00:22:01 And that's not to say they can just stop caring about customers, but I'm going to talk about it here in a second with the robustness ratio. um but he gives this comparison to like he kind of lost me at one point where he's talking about this speech he heard at the santa fe institute where he was like why do bigger animals live longer than smaller animals and i was kind of following along there was some anatomy there that i didn't really quite piece together but he basically says the skeletal structure is better suited to last um when it's bigger it's better suited for its environment He talks about the analogy between traditional high street retailing and Amazon's online model in the early days, which was you have to – if you are a traditional retailer, you've got to send stuff to the distribution warehouse. And then you have to wait for the stores, which have to have people that make customers happy. They have to have the right lighting. They have to have the right real estate. They have to have the right storefront, all this stuff to satisfy the customers. It's more complex and you're sending it to them when the store wants it.

Starting point is 00:23:10 Whereas with the online model, you're sending it to a warehouse and then you're sending it direct to the customer. The only part where you got to please the customer is in the speed of delivery and having a nice website, making it easy to order. So I think that's where he's talking about that skeleton is simpler to go from a mouse to an elephant than traditional retailing. But it's maybe not what... I don't think it's bad that Amazon adds a little more complexity to its business today because it has the resources to do so. Maybe, but would Costco spend $20 billion on Alexa

Starting point is 00:23:48 or would they give that money back to their customers and provide a better value? Costco would probably do the latter. Yeah, and maybe it's, you know, obviously it's two different choices, two different paths. We don't know what one's going to have a better outcome But I know for a fact that Amazon's customers will be more locked in if they use that cost savings from these experimental science project divisions to give money back to delivery costs, speed of delivery, all that good stuff. Well, let's go into another investment that they made, maybe a mistake, or definitely a mistake.

Starting point is 00:24:30 And it's one called AirAsia. Ryan was reading the letters as well. They talked about AirAsia quite a few times. It's a budget Southeast Asian airliner. I believe they targeted the stock because it looks similar to Ryanair, but even cheaper because it was in Southeast Asia and had a, quote, scaled economy shared strategy. Here's a quote from their letter when they first introduced the investment. AirAsia is Asia's largest low cost airline and probably the lowest cost airline in the world. The firm has borrowed heavily from Southwest Airlines model of operations.

Starting point is 00:24:57 The effect is that costs, including fuel, around three cents per seat per kilometer. Costs are very important when the product is more or less an undifferentiated commodity. And $0.03 compares to $0.04 at Ryanair, $0.05 at Southwest, or more importantly, $0.04 at rival Malaysian Airlines. The problem is, though, AirAsia did not really work out as an investment. I can't figure out exactly why. I'm sure there was just competition out there. Maybe the economies that they're in were struggling. Maybe, you know, I did read an article that they struggled during the pandemic as well.

Starting point is 00:25:28 And you can't really find a coherent stock chart, which is usually not a good thing because, yeah, they might have got absorbed by something else or whatever. But in the letters, they used to talk about AirAsia along with Costco and Amazon. So it looks like they had a lot of confidence here, but it was a wrong investment. I think the obvious lesson we can learn here, Ryan, is that no matter how confident you are in a competitive advantage, even with a company like Costco, it still pays to own, I would say, for individuals, probably at least 10. And I know Charlie Munger and people like that talk about five or less and having a few eggs and watching them closely. But diversification is not something you should forget, even if you're going for these high, high quality businesses that you have confidence in. Yeah, that's definitely part of it. Maybe the takeaway here is that it doesn't matter how good the airline is.

Starting point is 00:26:17 Airlines don't make for great investments. Don't forget about the industry. Yeah. Yeah. I mean, you look at Ryanair, like great model, wonderful model, really. And they've just stolen share over the last two decades. But the cash flow is completely, I don't want to say unpredictable, but it's really hard to forecast. And it's quite lumpy.

Starting point is 00:26:42 So anyway, I don't know. There's a lot of reasons I think that the AirAsia mistake might have happened. But I think it's the right takeaway, which is no harm in diversifying, especially for someone who is a minority investor in a lot of companies. You know, Charlie Munger has made that case that I think at one point he had one stock that was more than like, it was like 150% of his portfolio because he borrowed on margin. But at the time, I believe he was a significant shareholder. And so you can kind of dictate the outcome, whereas for most of us, we can't. So I would say, yeah, having more than 10 stocks is usually the way to go. Let's move on.

Starting point is 00:27:24 And I guess I don't really have any takeaway from AirAsia other than saying you can be wrong. No matter how smart you are, the future is uncertain and you can be wrong. So yeah, I think the basket approach in general with equities as minority investors is the right way to go. Let's talk about some of the frameworks that he used. I'll go through some of these. There were three that I found that were pretty useful, I think, for everybody. You can kind of apply this. And so I'll kind of go one at a time here. The first one, and I'll let you chime in as well, is scale economy shared. This is something that's constantly talked about by investors everywhere. And it's really, I don't want to say the perfect model, but it's definitely one of the models that leads to the best longevity for a company. So here's the quote of how he defines or Sleep defines scale economy of share.

Starting point is 00:28:24 So he says, scale – basically he says, 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 profitability

Starting point is 00:29:02 of long-term success. I love that. And yeah, it is really tough to do this if you're just like a mercenary CEO, if you've been brought in, you're not a founder, you don't have a significant stake in it, you haven't been around for a long time because you're measured by stock performance. Usually your shareholders dictate whether or not you are going to be the CEO for a while and optimizing for customers can hurt in the short term. It can hurt earnings per share and it's really hard to do. So this is definitely more common with founder-led companies or maybe like an auto zone where people have been executives or with the company for 20 plus years and they really understand what drives the business over

Starting point is 00:29:56 the long run. Any thoughts here on scale economy shared? Yeah, I think another way to put it is the non-zero-sum outcomes that a lot of people talk about as investors, where you don't just care about one part of your stakeholder base. You care about your suppliers, you care about your customers, you care about your employees, and you care about your shareholders. That's really the four, if you're looking at it from the executive's perspective who drive the bus here. I think this is similar where, look, they're not going to give no profits to the shareholders, but they're going to invest a lot in their customers, provide that value, retain that customer base to hopefully have durable, predictable profit streams that can grow over the long term and not just say,

Starting point is 00:30:40 you know, look, Costco could double their membership price right next year. People wouldn't, there wouldn't be that much churn and profits would go up a ton. But they probably will not do that because they have, they say, look, we can raise prices by 20% every five years in perpetuity if we retain that customer value proposition strongly enough. Yeah, I like that. And that kind of talks about the robustness ratio, which I'm going to talk about here in a second. The other thing I'm going to ask you this, put you on the spot here, what companies today do you think are employing the scale economy shared model? Okay, yeah.

Starting point is 00:31:22 We talked about this a little bit in our research conversation, so I'm slightly prepared. I will say some of the payments companies remind me of this, where you have someone like Adyen, who tries to lower costs and provide the best value for their customer as well, not necessarily saying we're going to eat all these profits, even though they have a 50% net profit margin, but that's kind of besides the point. They say they have a target there. i think wise one of your favorites does that as well where they're continually trying to lower costs as well as their competitors someone like remitly i'm trying to think of someone else here

Starting point is 00:32:00 maybe hmm what do you think i'm gonna look at my my watch list and see if anything pops up i'm looking at the uh my i did like a thread on this a while back Ryanair Wise I think is doing that Ryanair for sure Domino's I think does this with lowering the prices of their pizza or keeping them

Starting point is 00:32:29 as low as possible and they're able to do that because they spread their costs across this massive asset base and the marketing is really efficient because if it's digital marketing there's constantly a dominoes near you so it kind of applies to everyone so

Starting point is 00:32:49 savings there as well trying to think of some others um i got a good one that i looked at my watch list which it's really because they copied amazon and it is coupon uh the south korean east asian retailer the online retailer seems to be doing that uh learning lessons from the amazon and costco model as well at least i think so and for anyone that wants to listen further on that company. We've done multiple podcasts, interviews, and our own analysis on the stock. So nothing further there. Okay. Let's talk about, I'll start with the price to value ratio and then I'll go to the robustness ratio. So price to value, this one's a pretty simple concept, but it's basically the price of securities in their fund compared to what Sleep and Zachariah thought those securities

Starting point is 00:33:39 were worth. So in his letter, he states, when we evaluate potential investments, we are looking for businesses trading at around half of their real business value. That would imply a price to value ratio of 0.5. And this was sort of their measuring stick. They compared new ideas to the existing price to value ratio of the portfolio. So let's say they thought – so let's say the stocks were trading at $0.65. All their stocks combined in the portfolio were trading at $0.65. They thought the portfolio was worth $1. They'd have a price-to-value ratio of 0.65. If there's a new stock that they're looking at and it's trading for $1, they think it's worth $3. That's a price-to-value ratio of 0.3. That would be worth

Starting point is 00:34:27 potentially adding to the portfolio. There's some other considerations in there as well, but that's kind of what they mean. And I guess it's a complex way of saying that it's your opportunity cost. Basically, do you think you're getting more value out of this new investment than you would out of your existing portfolio? Is it better than your holdings as a whole? If the case is yes, then maybe it should be considered for a new position, but that's kind of the way they looked at it and it actually dictated the way they raised money so they thought basically they said this in a number of their letters was if we can't lower our price to value ratio of the portfolio with the opportunity set that they see at the moment they weren't going to raise new capital because

Starting point is 00:35:17 it was going to dilute performance all else equal so that's just a way of saying don't take new money if you don't have a place to put it. The third one here that I'm going to talk about, I guess any comments there on price to value ratio? Yeah, I think it makes sense. A good way to do valuation and comparing portfolio holdings and comparing your portfolio of when you want to raise money. The only problem is I don't, you know, what discount rate are they're using? I assume it's some sort of DCF type thing. There's always a lot of assumptions into this and there's a lot of probabilities. It's probably good, but definitely not like you don't want to get tied up into this and they talk about this in the letters too when you buy something that's 60

Starting point is 00:35:59 cents on the dollar right and you think it's a good business don't sell it when it goes up to a dollar you just want to keep holding it's a lot of people early on make that mistake of looking at the old buffett letters and the people that were deep value investors back in the day when you can find all these cheap stocks for huge discounts to literally just the cash on the balance sheet and then sell it once it gets to $1 or your estimate of intrinsic value. That is a huge mistake that they talk about. Or you're not updating your estimate.

Starting point is 00:36:29 Yeah, maybe it was worth $1 when you invested and today it should be worth $1.50 and you're still saying, oh, well, now you're using the price instead of its worth. It's not a precise science. Yeah, exactly. Let's talk about the robustness ratio. This is probably, I think, my biggest takeaway from the letters.

Starting point is 00:36:47 So robustness ratio is basically just a way of saying what percentage of a firm's excess capital or cash flow or cash at their disposal is going to shareholders versus customers versus employees, and they would actually build a pie chart for it. So I'm sharing my screen here and basically what it shows is just the first one is Geico and it shows of their excess capital, what percentage is going to shareholders? In this case, it's about a little over 50% goes to shareholders. 20, maybe 10% is going to employees and 40% is going to customers. And then if you look at Costco's, almost 75% is going to customers, looks like 15% is going to employees and 15% is going to shareholders. So a very small percentage of Costco's excess capital is getting returned to shareholders. Now, I think this helps for longevity. It's basically the business equivalent of deferred gratification. By passing up on taking that cash for yourself today, there will be significantly more cash to go around later on. And I do think it's an important caveat here. The percentage that should go to shareholders or customers or employees changes depending on the stage of – A, depending on the business model, but also depending on the stage of a business that you're in. If you're a startup, you probably shouldn't be rewarding shareholders as much. You should be optimizing for customers because the customers will become your best salesman and it'll help grow the long-term free cash flow that's available later on.

Starting point is 00:38:42 On the flip side, you take a look at a business like Visa. Would it really help them that much over the long run to give more of their excess capital back to customers? would would it really drive traffic that much drive more payment volume probably not yeah it's a bit of a different business model since they're not customer facing i think one question i would have for nick sleep today is is does he believe that amazon in 2021 was giving way too much value to the employees and not valuing the customer and the shareholders yeah yeah that's that'd be a fair question i think i think they've probably skewed

Starting point is 00:39:24 yeah i think as they've taken share they don't have to give back as high of a percentage to customers they can still reward customers but do it with less with with a smaller percentage of their excess capital. Yeah. I can see that point. I think if he had that thought though, he's not allowed to say that in public, right? Because people are going to get upset. But do we want to get to the next section or do you have anything else on the philosophies here, Ryan? No, I think it's an important exercise to run. Basically, whatever company you have, what do you think they're doing with their capital at their disposal? Is it going to shareholders? There are some companies where 90% should go to shareholders because they've got

Starting point is 00:40:09 nowhere to invest it. Or is it getting given back to customers? I think it's just a useful exercise for every company you've got in your portfolio. Finchat.io is the complete stock research platform for fundamental investors. They have all the standard financial data on more than 100,000 stocks globally. And beyond that, they have company-specific segment and KPI data on more than 1500 stocks. So to give some examples here, you want to see Netflix's average revenue per member over the last 10 years. They've got it. You like to track YouTube's advertising revenue. They've got that too. If you want to see Celsius's revenue that comes from Costco, how much of their revenue comes from Costco? They also have that. So the breadth of FinChat segment and KPI data

Starting point is 00:40:53 truly is one of a kind. I use FinChat every day to track and manage all my investments. I also use it to discover new investments. And if you want to get 15% off any paid plan, go to finchat.io slash chitchat. That's finchat.io slash chitchat to get 15% off any paid plan. The link will also be in our show notes. Earlier in the show, you heard us talk about the investing platform, public.com. That's where you can trade options with no commissions or per contract fees, and you get a rebate of up to 18 cents per contract. NerdWallet recently gave Public, five out of five stars for options trading. If you want to see why, go to public.com and start getting a rebate of up to 18 cents per contract traded. This is paid for by public

Starting point is 00:41:37 investing. Options are not suitable for all investors and carry significant risk. Full disclosures are in the podcast description, US members only. Yeah, and especially with consumer facing ones, it's probably the best way to look at it. For a consumer facing one, business to business, a little bit tougher. All right, we're going to talk about the next section is what did to get right about running the fund and the fund structure at the Nomad Investment Partnership. Since you led the last one, maybe I'll go first, give you a little talking break. I have three here. I think the fee structure was smart. They had a tiny management fee to pay for overhead costs that was basically not existent. Then they had a performance fee for each investor

Starting point is 00:42:13 once the investment hit a 6% annual hurdle based on the timing of the investment. So similar to the Buffett Partnership, not only is it a fair way to run an investment fund, but it helps to mitigate investors getting upset at a period of underperformance. No fees are paid and they can actually be clawed back using their strategy of a pulley system of fees, depending on if you earn the fee as the investment manager, and then the next few years you don't do very well, you can give a little bit of that back if there's underperformance over a multi-year period. And it's helpful, I think, as well, because when you go through a poor period, you do not want investors falling out when the market is in shambles. That's the worst thing you can have

Starting point is 00:42:54 as a professional investor. Second one I hear is communicating expectations for how the investors would act. Basically not telling them what to do, but telling them that they are smart and that therefore they will not be stupid when the market is falling like the quote unquote average Mr. Market investor. While doing so, I think he's kind of schmoozing them, telling them that they're hot, you know, whatever, I guess I'm not going to swear, but setting the table for a smooth operating period during the great financial crisis or other periods of underperformance. And not only did investors not pull out, they actually leaned in when the fund opened up to new subscriptions. And they talked about consistently about lowering fees for the

Starting point is 00:43:36 investors as much as possible, which I guess is probably taking those scaled economies, share the lessons back to the investor base and trying to basically make them as happy as possible and not go for the classic two and 20 strategy where it's like, well, we're still outperforming. We could charge two and 20 and still make you money. And it's like, well, is that actually fair? Now, the last one I have here is repetition. When reading all these in tandem, it can get quite boring. They repeat a lot of things, but they were great at once every six months, updating people on the tenets of their investing philosophy and saying, look, it hasn't changed. We're doing what we're doing. People understand what we're doing. I think Buffett does this as well. If you

Starting point is 00:44:13 read all Buffett's letters in tandem, especially the recent ones, they're quite boring. I mean, the earlier ones, yeah, they go into way more detail, but today it's much more simple. I'll have, let's see, I have something here as a screenshot, but I'll save that for the sub stack. Ryan, what do you have for your lessons on how they got right about running the Nomad Investment Partnership and why it was so successful. Yeah, maybe it wouldn't have seemed quite as repetitive if you were getting these on the regular cadence that investors were at the time, where it's every half year they're updating you on their philosophy.

Starting point is 00:44:49 But reading them one after the other, you start to go, okay, all right, I've heard all this before. But yeah, it is funny the way he kind of schmoozed investors, where he's like, dumb investors would pull out when things aren't going well when in reality that's the wrong thing to do lucky for us we don't have dumb investors you are smart it's like exactly it's like you wouldn't pull out your money right but he was saying what's smart is he was saying this when markets were doing well and he was doing it when he was doing well like yeah a lot of this stuff where it's like we you know we focus in the long term we uh don't let you know we're not measuring

Starting point is 00:45:32 ourselves by our recent track record what we care about is the next few years the next five years that's easy to do when things are going right so i guess for one thing he started this when he thought the opportunity set was ripe and that served him really well because the early returns helped it just really helps with the fun to have good returns early on i mean and exactly it was perfect timing for the ideas they were going after at the start, which is small cap, deep value, international investing. After the Asian crisis of the 90s, there was so many opportunities out there. And they kind of cleaned up with these, quote unquote, really bad businesses that were training at absurdly cheap multiples. Yeah. So I guess my lessons here,

Starting point is 00:46:18 same as you on the second one for me, expectation setting. He did a really good job of this. He He basically said all throughout his letters, something along the lines of, if we can't find opportunities, there's a chance we're going to shut this thing down. And that kind of forces you to keep your money in, I think, if you're an investor. Like, oh, okay, they haven't shut things down yet. That means they're probably seeing opportunities. The other one here is he wasn't eager to pull in new money. He was willing to wait until the opportunity set was right.

Starting point is 00:46:51 Not everyone, a lot of fund managers really can't afford this luxury, but it's one of the most difficult things about running a fund, which is when things are going well, that's when the fund is easiest to market, but that's not when you want fresh capital. So they would treat it as like, okay, we've got our investors on the sidelines. One day we're going to need you. One day we'll call on you, but that's not today. When we do though, we want to make sure you're ready. And having that same philosophy that's saying the same thing every year or so, it really keeps people like, okay, all right. Once I get that next chance to invest more, I will. The third one here, not capitulating on price. So there were times throughout his letters where you kind of got the sense that the opportunity set wasn't great, especially around 2006 during

Starting point is 00:47:45 their half-year letter. He said, we aren't taking on any new money because we can't find anything at the moment that reduces the price to value ratio of the fund. And so he didn't want to have to dilute the performance overall because you're selling based on performance. Even though the performance for a new investor or some of your old investors might be the same, it might still be good. The overall fund performance in aggregate might be worsened by taking on new money at the wrong time or taking on new money when you don't see the right opportunity set. So being patient even when the opportunity set isn't there. let's talk about our favorite parts of the letters. Why don't we alternate on this?

Starting point is 00:48:29 What were some of yours? Sure. And I'll have longer quotes for the newsletter. Again, you can sign up for that for free in the show notes and read all these quotes. I'm not going to do the whole thing. I think the first part is they talked about how cheap the market was in the dot-com bubble for small cap, deep value stocks. This is from page 30. If you want to look at this in the link that we'll provide in the show notes, according to empirical research Partners, an independent research boutique in New York. In 2003, the ratio of capital spending to revenues at US companies was at its lowest level since at least 1965, and free cash flow the highest compared to market capitalization. So essentially, he's saying things are really cheap, and then he

Starting point is 00:49:08 closes out this section with a little more details, and he says no man has been heavily concentrated in this category. Now, this is right at the start, right, right, kind of when the dot com bubble is bursting. I want to ask you here, Ryan, do you think the style shift, when they went from deep value at the start here, because that was the best opportunity set, to these kind of permanent holdings, compounders type stuff in perfect timing, right? Right after the GFC, when a lot of that stuff was cheap. They talk about the changing of the styles, right? And most of them moving the portfolio over to that. Do you think that was mainly because that's where the opportunities were? I mean, if valuation matters to them, and there's a lot of people

Starting point is 00:49:47 out there that take the never sell mentality from Nick Sleep and the Nomad Partnership, but I think don't apply valuation to it, or at least maybe they were doing it a lot more in 2020 and 2021, and maybe fewer people are doing it today. But I kind of think that that shift in strategy, when they communicated to the investors in their letters, they didn't say, hey, this is where the opportunity is. They said, this is what we can understand. But I think a lot of it was because look in 20 uh in 2006 to 2011 there wasn't really much opportunity in deep value at least from a factor perspective like the overall opportunity set was much worse uh just because it had done so well over the last uh five years but the opposite effect the compounders the

Starting point is 00:50:27 large cap compounders were uh as cheap as they've ever been yeah i don't know if it's them like having an epiphany in 2005 where they're like you know what these these bigger businesses these competitively advantaged companies they're way easier to own or so he he doesn't ever like say all of his holdings and i wonder if kind of between 2005 and 2006 he had a lot of those deep value small caps in countries where it's not super easy to invest and maybe they they weren't really getting the results out of that that they wanted well hey costco at the start when they first made the investment was only three percent of the nav of the nav so they didn't size it up at all at the start yeah i don't know what necessarily

Starting point is 00:51:24 caused the shift um but it was the right thing to do good timing nonetheless yeah yeah all right what's your first one i'll take this one just because it's something i think everyone can try to apply um so he says uh this is early on on page 16 he goes we can for example buy common shares preferred shares debt or convertible bonds in analyzing a company we assess the merits of investing in all levels of the capital structure. We've seen this time and again, actually, with a number of investors where it's like, we are asset agnostic. We're not just only looking for common equities. We're looking across the capital stack. It really helps not only, maybe all you do is invest in common equities, but by understanding the opportunity for every element of the capital

Starting point is 00:52:16 structure for a company, I think you have a better grasp on the actual equity itself. So I just think it's helpful. It kind of makes you a more rounded investor and helps you understand what you're actually buying a little better. Yep. All right. My second one here is not caring about the index. This is one that I'm trying to learn to be a bit better on, but it is tough because every brokerage you use, when you look at your performance, they always compare it to the various indices. So it's right there, whether you want it to or not. But here's the quote, page 103 from the letter file. It says, Zach and I have witnessed many investors make terrible investment decisions from thinking

Starting point is 00:52:54 via the index. The most common mistake is to view the index as a risk-free, quote-unquote, home. This disposition still exists after the irrational index bubbles that preceded the Asian crisis and technology collapse may be testament to the strength of the marketing skills of the financial establishment once the index is seen as risk-free the mistakes that follow cascade and include they go through a bunch of stuff about you know how they use that as almost a pricing tool or it's like hey well don't worry we outperformed the index or when they came across one badly performing manager and they said that they had a index in their home country and they own part of that and they said it was quote-unquote a global diversifier and a global fund and they poked fun

Starting point is 00:53:39 it and said many a furrowed brow these last few weeks figuring out what that means uh you can tell that these guys are british but i think it's a good point because a lot of people look at their performance versus the index to compare it to that and they say hey you know we've done that in the past i mean it's it's it's not important because it doesn't matter necessarily what the index does if you're not investing in it because regardless of what the index does it only matters what your portfolio holdings do to build your wealth, your retirement nest egg, whatever your goal is in investing. Yeah. I like that. And it's definitely easier in theory than in practice because you always want to compare yourself to the index since that seems to be everyone's

Starting point is 00:54:24 opportunity cost. But yeah, I think it's important to try to not care. All right. I'm going to move to my second one here. This is Sleep describes the most, the companies or Sleep and Zachariah Limited's Nomad Investment Partnerships, most common mistake. This isn't their biggest mistake, but it's the most common one they made. And I'll just go through the quote here and then I'll kind of sum it up in the way I understand it. It says, our most common mistake is to misjudge capital allocation decisions by our companies. Firms which articulate a share repurchase, debt repayment strategy and have incentives to reinforce that outcome, throw caution to the wind and make acquisitions instead. In other words, you get empire builders, companies where even though

Starting point is 00:55:14 they've espoused, oh, we're going to return capital to shareholders. That's great. All of a sudden, they start acquiring companies. And I can't remember the number, but most acquisitions, most corporate acquisitions do not work they are not good for shareholders um and i think it's like a really high percentage so i don't know kind of internalizing that there are some companies i own where it seems like they're making a lot of acquisitions and i would rather just have them returning capital to shareholders autodesk come into mind uh maybe uh maybe i should consider that a little more. Yeah, possibly, possibly. Okay. My third one, it's reiterating the advantage of patience. If you have the analysis on the business correct, I'm not going to read the

Starting point is 00:56:04 full one here. This is on page 104. Quote, good investing is a minority sport, which means that in order to earn better returns than everyone else, we need to be doing things different to the crowd. And one of the things the crowd is not is patient. Readers of our letters may be familiar with the notion of the equity yield curve and our thoughts were covered in an interview, blah, blah, blah, blah. And then he closes it out and says, in other words, parentheses, at this point, economic students may wish to cover their ears. Close parentheses. The return from investing in shares can be both increased and de-risked with time. So I think that is, again, something that's almost always underrated. I mean, it continues to get even better

Starting point is 00:56:43 as an underrated tactic because of the decrease in the average holding for investors that has happened over the last few decades. And it's a good something to reiterate now. I don't think we have to do anything more on that. It's something we talk about a lot on our show, but he's another great investor that talks about that. Almost all the great investors talk about this. I think it's something investors should think about if you're a heavily active trader. All right. I'll go to my third one here. And so last one I mentioned was the most common mistake they made. This is the biggest mistake. It says, the biggest error an investor can make is the sale of a Walmart or a Microsoft in the early stages of the company's growth.

Starting point is 00:57:27 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. And he said this because they had bought Amazon and the stock was starting to rise in price pretty quickly. And so they had great returns. And he says, And it ended up being very pressing. It says, would selling Amazon today would be the equivalent mistake of selling – we wonder, would selling Amazon today be the equivalent mistake of selling Walmart in 1980, a similar time period after both companies' IPOs? So he nailed it. And then he nailed it again by selling Amazon, aka Microsoft, in 2000, selling Amazon in 2021.

Starting point is 00:58:20 Yeah. Yeah. So I guess this kind of, you've got one more lesson here and then we can kind of give our takeaways. Yeah. And on that one, I will say it's a lesson in reinvestment runway. When they were talking about that, there was such a huge reinvestment runway for Amazon that there was no reason to sell regardless of the valuation. But when it's valued at $2 trillion and it's way more mature as it was in 2021, yeah, valuation is going to take a bit more factor into the equation. Let me close this one out here. It's something that both of us, I think, loved reading because we gripe about studying companies and the management teams out there. It says, quote, on page 171, judging by our hit rate with companies

Starting point is 00:59:01 interviewed, Zach and I would guesstimate that fewer than 5% of publicly listed firms do what they think is right rather than what they think plays well at the outside world. Even so, the vast majority of Nomad's firms do what is right long term, but I suspect we have a predilection for such people. I think that's a good number. 95% of the companies you look at, and maybe this is just the McKinsey brain infecting executive suites across the country. That's the mind virus I think the world needs to be worried about. But I think that's right. If an investment team just speaks in platitudes, if they don't talk about actually focusing on return on invested capital, The things that are going to matter for shareholders, all the tough stuff we talked about in this letter, scale economy shared, sharing stuff with all our shareholders, excuse me, stakeholders, including our shareholders, non-zero-sum games, building a good brand, blah, blah, blah, blah, blah.

Starting point is 00:59:55 That's what matters. You know, read some investment conference calls. A lot of it's just, well, what's the margin going to be next quarter? Oh, I think it can rise by 20 basis points. Okay. You know, like the companies focus on that. And yeah, I think that sums it up. Okay. Let's go through our closing thoughts here. We're kind of wrapping things up.

Starting point is 01:00:17 What were some of your biggest takeaways after reading these letters? Okay. I have four. One, to beat the average investor, you have to be different than average. If you are just piling into what is popular on Wall Street, cough, cough, NVIDIA right now, the financial media are actively trading. It is likely you will do average or worse than the average investor. Two, ignore the index completely. This is something I guess was maybe my biggest lesson from them, something I need to do better at. Three, stay patient. One of the only advantages small-time investors have is patience. Four, when you find a great company that you understand and can buy at a reasonable price,

Starting point is 01:00:57 three criteria, not just one. It should take a huge overvaluation for you to sell that stock. an example again of this is sleep selling amazon in 2021 according to the richer wiser happier book i will say confirm all the details on that from the book i don't know how much he sold i can't remember exactly but look at those before claiming that you know taking us uh as fact there especially because of how secretive they are all right ryan as we wrap up what are your four final takeaways. Yeah. One of the first ones is

Starting point is 01:01:31 one of the worst things that an investor can have is a self-serving management team. So they talked about this a bit where they were like, we didn't even set out hoping to get founder-led companies, but that's what we ended up with

Starting point is 01:01:45 because they were the most honest and they seemed to be check all the boxes that we wanted from a capital allocation standpoint. So basically just saying like, the incentives were aligned. So you don't want a self-serving management team. The other one, don't capitulate on price. They were usually very stringent on this. I guess

Starting point is 01:02:09 you could say Costco was maybe expensive at 25 times earnings, but they found the right way to make sense of it. Third one here, when there is a big reinvestment runway, companies have more capacity to allocate capital towards customers over shareholders. And I really like that. Basically, companies with huge reinvestment runways and they're rewarding customers, that's a good setup. The last one here, and this is not a novel takeaway, but hold your winners. I talked about it. Biggest mistake anyone could have made is you find a Walmart or a Microsoft and you end up selling it in the early stages of its growth. We've studied a number of investors now,

Starting point is 01:02:52 and that seems to be the biggest takeaway, is they held winners for a long, long time, longer than most people. They had to sustain over periods of overvaluation. You saw with Norbert Liu, they saw NVR some significant multiple expansion while he was owning it. You're seeing it here with Amazon. I'm trying to think of some of the other ones. I guess you could say Stan Druckenmiller kind of did that with NVIDIA, although it did eventually

Starting point is 01:03:20 sell. But I'm going to take away one concrete lesson here. New philosophy for me, every stock I buy, I will at least hold for three years because the outcome – and I should probably have that strategy to begin with. But the outcome in that timeframe is so uncertain. but by that point, I think after three years, you have a better idea of what companies are actually winners. Because anything can happen in that short of a time span, like the stock can jump up and you feel like it's a winner. It can drop, plummet, you feel like a loser. But I think over three years, you see the improvement in true underlying results. Spotify is an example that comes to mind for me. We bought at a steep price initially,

Starting point is 01:04:12 And I thought, well, this, this is not a winner, quote unquote, but over time it's proven to be a winner. And you're starting to see that more and more in the fundamental improvement. And so I think three years kind of just gives me enough timeframe to really decide whether or not this is something I should actually cut. All right. Yep. I think that's a good way to wrap things up. Let's hit some housekeeping items. If you listened to this full episode, I think you got some good value out of this podcast and the best way to give back to us if we're going to do scale the economy shared strategy here is to give us a review on Spotify, Apple Podcasts, follow us on YouTube, follow us across all those podcast platforms or really whatever one you choose

Starting point is 01:04:52 and share this, tell someone about it. If you're on the old Twitter machine, give us a little retweet on that show. That is the best way to support us as a free ad supported network because as we grow, we can actually spend more time on the podcast as we make more money through the advertisements and hopefully give better value back to you, the listeners. There you go. A little lesson there at the end of the day. Let's hit the disclosure. We are not financial advisors. Anything we say on the show is not formal advice or a recommendation. Ryan, I, or any podcast guest may hold securities discussed in this podcast, may have held them in the past and may buy, sell, or hold them in the future. Thank you everyone again, and we'll see you next time.

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Chit Chat Stocks - Nick Sleep: How The Secretive Investor Crushed The Market With Concentrated Compounders

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