Nicholas Sleep and Qais Zakaria are not names that immediately come to mind when you think of investing greats. But Financial Times points to a superb track record. During the 12 years they ran Nomad Investment Partnership (2001-2013), the fund returned 921.1%, or 18.4% per annum after performance fees. Here are some insights from Nicholas Sleep’s letters to partners with respect to an overload of information when analysing a company.
When naturalist David Attenborough was introduced on BBC Radio 4’s Desert Island Discs as “you have seen more of the world than anybody else who has ever lived”, he humbly pointed to “…the greatest naturalist that ever lived and had more effect on our thinking than anybody, Charles Darwin, only spent four years travelling and the rest of the time thinking.”
Notice the model of behaviour he observed in Charles Darwin: Study intensely. Go away. Really think.
In other words, the human mind trumps endless data collection. The frontal cortex of the brain, which is charged with rational thought and information processing, can make more sense of the world, given enough time to think it through, than the senses themselves can.
In today’s information-soaked world there may be stock market professionals who would argue that constant data collection is the job. Indeed, it could be tempting to conclude that today there is so much data to collect and so much change to observe that we hardly have time to think at all. Here’s why we don’t agree.
De-emphasise the data collection and think.
When we study truly great businesses, we find that very often it has been simple human attributes that have led to their success: you feel differently drinking a Coke than a no-brand cola. You feel differently towards a business that consistently undercuts the competition in price or, a delivery service that literally goes the extra mile and picks up returned items. And the reason you have these feelings, and the stimuli that produce them, have hardly changed in millennia.
When we try to understand the factors that made great businesses great, there is lots of time to think. For example, it is interesting to note that the business model that built the Ford empire a hundred years ago 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 10 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.
The journalist and technologist, J. P. Rangaswami, argues that the most helpful way to think about information is the same way we think about food. “When I saw Super Size Me I started thinking, now what would happen if an individual had 31 days nonstop Fox News?” he said in a speech.
Clay Shirky, the writer and internet consultant, claimed that “there is no such animal as information overload, only filter failure” which, using Rangaswami’s analogy, implies we need to think about data diets and information exercise to prevent the build-up of toxins and disease.
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 we weigh most heavily in thinking about a firm is that which has the longest shelf life, with the highest weighting going to information that is almost axiomatic: it is, in our opinion, the most valuable information. No doubt Charles Darwin would agree.
There are so many distractions: news items, the soap opera of the stock market, macro-economic events, politics, currencies, interest rates, principal/agent temptations, regulation, compliance, administration and so on - this list is not exhaustive!
It is all too easy to make things more complicated than they need to be or, to invert, it is not easy to maintain discipline. One trick that we use when sieving the data that passes over our desks is to ask the question: does any of this make a meaningful difference to the relationship our businesses have with their customers? This bond (or not!) between customers and companies is one of the most important factors in determining long-term business success. Recognising this can be very helpful to the long-term investor.
For example, what investors needed to understand, and attribute sufficient weight to, in order to hold Colgate-Palmolive shares for the last 30 years, and so enjoy the 50-fold uplift in share price, was the economics of incremental products (often referred to as “line extensions”, from the first Winterfresh blue minty gel in 1981 to Total Advanced Whitening today) and the psychology of advertising. Other items were important too, discipline in capital spending in particular, and there were lots of other things that seemed important along the way (stock market crises, country crises, management crises and so on) but it was the success and economics of line extensions and advertising that, in our opinion, was what the long-term investor really needed to embrace.
A similar story can be told at Nike and Coca-Cola (manufacturing savings funnelled into dominant advertising) or Wal-Mart and Costco (scale savings shared with the customer).
Recognising and correctly weighing this information in-spite of the latest news flow is a matter of discipline, and it is that discipline that is so richly rewarded in the end.
Sometimes, there is no smoking gun.
An auto insurance company. There is little product differentiation across the industry and the customer purchase decision is usually driven by price. This is a soul-less relationship: it is near on impossible to get customers to love their insurance companies and, for their part, insurance companies don’t give the impression they love their customers much either.
Be that as it may, the firm we visited has a wonderful track record of financial results going back decades. Not just good by insurance industry standards, but good by any standards. So, what is going on? It is tempting when analysing such situations to look for the smoking gun that explains the firm’s success.
A smoking gun may be a vivid image, but the world does not always work like that. I should have known better when I asked what big idea had led to the firm’s success: “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”.
I have heard this line frequently over the years and have always dismissed it. And I think that all this time I may have been wrong.
Costco Wholesale: Costco’s advantage is its very low-cost base, but where does that come from? Not from low-cost land, or cheap wages, or any one big thing but from a thousand daily decisions to save money where it need not be spent. This saving is then returned to customers in the form of lower prices, the customer reciprocates and purchases more goods and so begins a virtuous feedback loop.
The Welsh insurance company was founded by a man who cared passionately about the little savings, and he institutionalised this orientation into the culture of the firm from the beginning. It was the way they lived, it was part of their raison d’être: it was plan A. And they shared that saving with their customers. Although I was slow to grasp the point, the insurance firm’s advantage was very similar to that which had built Costco and Amazon. My mistake in not recognising that these businesses share similar roots might be termed by psychologists as a “framing” error.
When looking for an explanation to a situation the brain tends to latch on to what can be easily found to “frame” the situation, and if what is easily found is also vivid, then the brain stops looking for another explanation. I had gone looking for what I thought ought to be there, a vivid smoking gun such as a brand name, a location, a clever reinsurance contract, or a patent. However, there is no a priori reason why a comparative advantage should be one big thing, any more than many smaller things. Indeed, an interlocking, self-reinforcing network of small actions may be more successful than one big thing.
Let me explain. A successful drug firm does not need to be particularly good at marketing, manufacturing, or research and development for that matter if, through a patent, it has a legal monopoly on a drug. But just look, if you will, at how fragile the drug company ecosystem is. A rival could displace it at any time with a better chemical and the firm would be left with little to fall back on, certainly not marketing, R&D, and manufacturing. Its period of exceptional profitability may therefore be quite finite and the big drug firms wrestle with this issue today.
Contrast this with a scale economics business: To better an incumbent’s cost base a rival would have to be superior at, not one thing, but a million little actions – a far harder task. An Amazon letter to shareholders contains the following section: “…We believe that focussing our energy on the controllable inputs to our business is the most effective way to maximise our financial outputs over time…we’ve been using this same annual [goal setting] process for many years. For 2010, we have 452 detailed goals, with owners, deliverables and targeted completion dates”.
At Amazon, one employee initiative to remove the light bulbs from the vending machines saves the firm $20,000 per annum! At the Welsh insurance company, the penny dropped: 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. And if they are harder to beat then they may be very valuable businesses indeed.
Play the long game and be a calm hand on the tiller.
When investors value a business, consciously or not, it is a decision tree with the various branches leading to all possible futures and probabilities attached to those branches. The share price can be thought of as an aggregate of the probability-weighted value of these branches.
This is not an accurate representation of what the future will be. The next step for the company will not be to visit all of those branches simultaneously. In reality, the firm will only visit one of those branches before proceeding to the next and so on.
Short-term investors spend their time trying to handicap the odds of each branch. Guessing which-branch-next can be a crowded trade, but it’s fine, as far as it goes. However, it misses the big picture.
We propose that some businesses, once they have progressed down the first favourable branch, stand a much greater chance of progressing down the second favourable branch, and then the third, as a virtuous feedback loop builds. The process takes time, but a favourable result at any one stage increases the chances of success further down the line, as it were. Think of it as a business’ culture.
Take Air Asia:
- Branch 1: The firm was born with a no frills, cost culture with the result that, we estimate, it is the lowest cost airline in the world.
- Branch 2: The employees take pride in the firm, suggest their own savings and the savings are implemented.
- Branch 3: The savings exceed the peer group and are given back to customers in the form of lower prices.
- Branch 4: The customer reciprocates and revenues rise.
- Branch 5: Further scale advantages lead to more savings per seat flown.
- Branch 6: Further customer reciprocation.
- Branch 7: The network builds and crowds out other, less efficient airlines.
- Branch 8: Competitors go out of business?
The point is that the odds associated with any of these branches are not static but, in a hugely important way, they improve as one travels from branch to branch. Imagine the payoff in a game with these attributes. If investors recognise the inevitability of these improving odds they are also usually indifferent to them, perhaps viewing the eventual greatness of a business as simply outside their time horizon. Nevertheless, the effect of this indifference on share prices is to leave long-term success undiscounted (note, share prices are an aggregate of all possible future worlds, not the actual future) and the rewards from that observation may be enormous for the patient few.
The opportunity for investors comes from realising to whom these firms are more valuable. Certainly not the short-term investor, who will be indifferent as to whether Amazon, Asos or Air Asia will be the most valuable retailer/fashion retailer/airline in the world in 10 years. This myopia presents the true long-term investor with the spoils, but the mechanism for this wealth transfer from short-term holder to long-term investor is subtle.
