A couple of weeks ago, Frederik Gieschen published a summary of the Nomad Investment Partnership letters.
The story of Nomad is worth retelling: in 2001 a young man named Nick Sleep partnered up with another young man named Qais Zakaria to form an investment firm, first under Sleep’s employer, Marathon Asset Management, and then later on as the Nomad Investment Partnership. They were uncommonly principled investment managers, both in terms of style, but also in terms of their compensation — Sleep and Zakaria charged 10 basis points as a management fee for their fund, far lower than the industry standard of 1-2%. They also committed to earn their 20% share of the profits after generating a 6% annual return. A few years into the firm’s life, they stacked the deck further against themselves: they placed their 20% share into a bucket for a few years, and told investors that they would refund a portion of those previously earned fees if Nomad ever fell short of its 6% annual hurdle rate.
You can sort of squint at Nomad’s setup and say that they were playing a scrub game. But you’d be wrong. Over the course of the next 13 years, through the 2007 financial crisis and out to the other side, they returned 921.1% to investors, roughly 10 times the original capital invested with them in 2001. In 2014, Sleep and Zakaria decided to close the partnership to retire at the ripe old age of 45. They did so because they were bored: they thought that investment was a fun intellectual game, but that they had solved the game. They were ready to move on.
Author William Green writes, in Richer, Wiser, Happier:
Many funds “start with lots of cake as their goal,” Sleep writes in an email. “It’s not the cake that gratifies us. What we found gratifying was the process of solving the investment problem, learning along the way and doing as good a job as we knew how—they are all internal personal goals. The cake was then a (happy) byproduct.”
The frame that Gieschen picked to tell their story has haunted me ever since. Gieschen describes the evolution of Sleep and Zakaria’s investment style as an applied instance of Charlie Munger’s ‘take a simple idea and take it seriously’.
In the beginning, Nomad invested in ‘cigar butt opportunities’ — that is, so-so companies that were valued at unreasonably low prices. This included, amongst other investments, four Zimbabwean stocks, all of which were valued at a ridiculous amounts to book value (one cement producer they invested in was valued at one-seventieth of the replacement cost of its assets — you could, in theory, buy the entire company for 1/70 of the price of everything it owned). When they exited the last of their investments in Zimbabwe in 2013, Sleep and Zakaria gifted each Nomad investor a worthless banknote for 100 trillion Zimbabwean dollars.
Over time, however, Sleep and Zakaria began to dislike these ‘cigar butt’ investments. They realised that if they kept buying such companies, they would have to repeatedly exit their positions and find new ones, since these mispriced businesses would eventually rise into more reasonable valuations. The duo began looking for opportunities where they could park their money for longer periods of time. They wanted compounders — great companies that could grow.
And so they began to ask a series of very interesting questions.
It is mostly this series of questions that interests me. To hear Gieschen tell it, Sleep and Zakaria stumbled onto their big idea with a chance investment in Costco in 2002, right after its stock tumbled from $55 to $30 (the market was apparently concerned with the company’s low profit margins; Sleep and Zakaria were attracted to the company’s ‘every-day-low-pricing’ model).
Sleep wrote, at the time:
This is a very simple and honest consumer proposition in the sense that the membership fee buys the customer's loyalty (and is almost all profit) and Costco in exchange sells goods whilst just covering operating costs.
(...) By sticking to a standard mark-up savings achieved through purchasing or scale are returned to the customer in the form of lower prices, which in turn encourages growth and extends scale advantages. This is retail’s version of perpetual motion and has been widely employed by Wal-Mart among others.
(...) Costco management describe the strategy as “easy to understand and hard to operate" perhaps because the temptation is to mark up the goods and break the contract with the customer.
(...) Costco is as perfect a growth stock as we have analysed and is available in the stock market at a close to half price.
Over the next few years (and visibly, through the investment letters) Sleep and Zakaria began to realise that there was something truly special about Costco’s model. They started asking themselves what this special property was, how they might recognise it when present in other companies, and what the second and third order implications were.
In 2004 Sleep wrote, again of Costco:
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. In the centre 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.
This was the first instance of the phrase ‘scale efficiencies shared’ in their letters — Sleep and Zakaria’s name for this particular property. (They later renamed it ‘scale economics shared’, but the idea remained the same). Sleep and Zakaria took this single insight and took it very, very seriously, eventually working out all of its possible implications, and shifted their fund to be fully invested in companies with this property.
Gieschen traces the sorts of questions they asked over the course of their partnership. For instance, in 2004: “What characteristics could one bestow on a company that would make it the most valuable in the world? What would it look like?”
Such a firm would have a huge marketplace (offering size), high barriers to entry (offering longevity) and very low levels of capital employed (offering free cash flow). Costco has some of these attributes. The range of products is as wide as any retailer, and by-passing savings back it is building a formidable moat. It is also more asset light than its peers, but it is not the lightest of them all. For that one must turn to the Internet. In our opinion a business such as eBay could be the most valuable in the world. It has a huge marketplace, the biggest, an auction marketplace naturally aggregates to one player, offering high market share and high barriers to entry to the winner. Product pricing may be supported by the incumbent local newspapers and publishing businesses which have expensive machinery to replace and usually unionised labour and may provide a price umbrella for eBay. Better still eBay makes the customer pay for a high proportion of the assets used in the transaction such as PCs, modems, phone lines and so forth. But best of all, the incremental assets required to grow are so small. At Costco the firm will spend around U$15m per incremental store which will serve a radius of perhaps thirty miles. U$15m is a lot of servers for eBay, and whilst we are not experts, that may be enough to serve some countries. So no, Costco is not perfect. Perhaps we should own eBay as well.
(It’s worth noting that at this point, Sleep and Zakaria were already looking at Amazon. A year later they began buying shares of the retailer; a year after that they took Amazon up to 20% of the fund, and asked permission from their investors to go above the concentration limit. A quarter of their investors balked and redeemed. Sleep and Zakaria went ahead anyway.)
Sleep then asked what other companies shared such a property:
While reading the 2005 Berkshire Hathaway Annual Report, one paragraph stood out for us as Warren Buffett referred in passing to the division of operating and underwriting cost savings at motor insurer GEICO. These “benefits” were divided between shareholders, policy holders and employees and the statistics spelt out in some detail.
For example, it is interesting to note that the business model that built the Ford empire a hundred years ago and is illustrated in the chart below (dated 1927), is the same that built Sam Walton’s (Wal-Mart) in the 1970s, Herb Kelleher’s (Southwest Airlines) in the 1990s or Jeff Bezos’s (Amazon.com) today. And it will build empires in the future too. The longevity of the model is not difficult to understand as Jeff Bezos pointed out “I can’t imagine that in ten years from now customers are going to say: I really love Amazon, but I wish their prices were a little higher” or Amazon was less convenient, or they had less selection.
And then they asked what was so difficult about this model, and why it was so rare, even amongst companies with scale economies:
What can Investors learn from Scaling Laws? A business ought to be able to self-fund its own growth, and if the opportunity set is large, then the return on capital needs to be suitably high. Second, barriers to entry should increase with size; that way a company’s moat is widened as the firm grows. To do this, the basic building block of the business, its skeletal structure, is probably best kept very simple. In short, we want a skeletal structure that can support growth from mouse to elephant without too much skeletal reengineering.
In 2010, Sleep began to realise that culture was an important explanatory variable for the model:
Cultures that care about the little things all the time are very hard to create and, in the opinion of Amazon.com founder Jeff Bezos, almost impossible to create if not put in place at the firm’s genesis.
“No, no, Nick, there is no secret sauce here”, one senior executive explained, “we don’t do one thing brilliantly, we do many, many things slightly better than others”.
And when they asked why other investors hadn’t noticed the power of scaled economics shared, like they had, they came up with the following reason:
Misanalysis, or using the wrong mental model: Investors are used to firms which have one good idea, such as a new product, but then struggle to replicate success and end up diluting return.”
(…) Structural or behavioural: Active fund managers have to look active.
(…) Odds or incorrectly weighing the bet: In the words of my first boss, investors tend not to believe in “longevity of compound”. Conventional thinking has it that good things do not last, and indeed, on average that’s right!
(…) No doubt some combination of these, plus others, acted in the minds of sellers. It matters not particularly. What matters is the effect of this collective miscognition. 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.
It’s worth taking a step back here to consider what Sleep and Zakaria were doing.
In my 7 Powers summary, we discussed how the central question of business strategy appears to be ‘how do I prevent my business from sucking?’ — that is, how do you resist margin compression as a result of fierce competition? Author Hamilton Helmer argues that there are really only seven ways businesses may resist margin compression; he calls this the ‘Seven Powers’, and then lays out the implications of each Power over the course of so many chapters.
Sleep and Zakaria recognised this reality of business, though they phrased it differently — they asked: “what is it about growth stocks that dooms them to failure?”
The answer is that success encourages competition, and capital flows into an industry to compete away the excess returns. Like all heuristics, this works most of the time, and we can all think of businesses that were super profitable for a while before the competition caught on. But what of those that don’t fail? Michael Dell succeeded by keeping costs low and passing back his scale benefits to the buyer of his PCs. By the time the competition had matched him in pricing he had moved on. And on and on. Amazon.com may be following this path as well. So, the first point is that whilst Costco continues to recycle cost savings to the consumer, it is lowering the probability of failure.
And then, after asking this question, they went one step further. They asked: of all the possible business models in the world, what is the best possible business model? To paraphrase using the language of 7 Powers, of all the possible Powers, what, pray, is the best Power?
By 2010, eight years after first investing in Costco and six years after first writing about Amazon, it was clear from their letters that Sleep and Zakaria had settled on an answer. They believed that the best business model was one where the defensibility emerged from scale economies — but with a twist: if the cost savings from those same economies were shared with the end consumer, the odds of plateauing growth were considerably lower.
I think it’s worth thinking about one other implication of Nomad’s insight. Sleep and Zakaria imply that not all moats are created equally. It’s tempting to think that if a moat produces overwhelming pricing power, this results in unparalleled profits and therefore acts as an unalloyed good. The Nomad letters hint that this isn’t necessarily the case. What matters is durability of compounding growth. So, for instance:
- Strong network effects often leads to an overwhelming monopoly for the incumbent, and tends to provoke some form of regulatory crackdown or consumer backlash over the long term.
- Strong brands give businesses pricing power, but do not prevent the entrance of new competitors with equivalently strong brands, nor protect the company from the disadvantages of scale (in fact I might go further and argue that scale sometimes works against the brand, depending on the brand narrative in question).
- Switching costs creates disgruntled customers over the long term.
- Counter-positioning is not a complete moat, as Helmer likes to point out.
- And, finally, cornered resources and process power do not guarantee returns to scale.
In contrast, a business with scale economies shared passes on the benefits of its growth to its consumers. This aligns incentives rather wonderfully, and it turns out to be somewhat difficult for a regulator (or even a set of consumers) to crack down on a business that so consistently passes on its profits to its customers.
They were acutely aware of how little in life we ever truly know. But they knew that they had uncovered a deep truth. “That’s the best single thought you may have ever had in your life,” says Sleep. “It needs to dominate everything because you’re not going to get many insights like that. Everything else is a bit low quality, isn’t it? It’s a bit transitory. It doesn’t make a big difference.
Today, Sleep and Zakaria invest their own money ... for charity. You may find the full collection of Nomad letters here.
Take Good Ideas and Take Them Seriously
This is the last blog post I’m writing in 2021. At the start of this year, I wrote a piece titled What Bill Gurley Saw, which told the story of Benchmark venture capitalist Bill Gurley through the lens of a single, illuminating idea.
So, again: what did Bill Gurley see? I think the right answer is this: Gurley was one of the few people to have deeply internalised the implications of Arthur’s ‘increasing returns’ theory; he understood more about network effects and networked marketplaces than just about anyone in tech at the time. (In the podcast with O’Shaughnessy, Gurley bemoans the overuse of the phrase ‘network effects’, saying “everyone’s heard it and repeats it so it’s been polluted … having looked at so many different businesses over the years now, there are (actually) different levels of it.”)
So when the ride-hailing opportunity turned up, Gurley was well prepared for it. He must have gone after Taxi Magic/Cabulous/Uber the same way he went after any startup that looked like it could take advantage of ‘increasing returns at scale’. And because he had sat with the problem long enough, and because he had more experience with more networked companies than others, he could recognise when an operating team had figured out ‘liquidity quality’, and then go all in on them.
Of course, Gurley did get lucky — everyone who is wildly successful gets lucky at some point. But it’s not too much of a stretch to say that Brian Arthur’s paper helped Gurley see the future; it does seem like his investing career has been defined by the nuances of a single, wonderful, idea. And it probably explains why — now that he’s squeezed all the returns out of that one idea — Gurley announced, early last year, that he was finally going to stop. Arthur’s idea helped Gurley see the future, but now the future he saw had finally arrived.
It seems fitting that 2021 is bookended by two stories of careers that were built around taking a simple idea and taking it seriously. I say this because I feel like this is what I’ve attempted to do with this blog. Over the past year, we’ve taken a look at tacit knowledge (in business), believability, expertise acceleration, and competitive advantage and then examined their implications to a degree that I think may be considered abnormal.
If you find a useful idea, it’s probably worth it to work out all the second and third order implications before moving on. I hope you’ve found this style of thinking useful, and that you may use it in all your other endeavours in the new year ahead.
Happy holidays, and godspeed. I'll see you on the other side.
Originally published , last updated .