Annualized since inception: % % Before performance fees 18.9 4.9 After performance fees 16.6 The figures above are unaudited, presented on a cumulative, percentage gain basis and, as ever, are before fees. We present results in this way as Nomad’s refundable performance fee and time dependent performance fee hurdle mean that the net-of-all-fees results will vary with subscription date, and from investor to investor. Partners will, therefore, each have their own, unique, net-of-all fees experience of investing in Nomad. As a guide, we have also detailed the net-of-all-fees results from one point in time, in this case since inception. An index is used in the table to place our results in context with a broad swathe of share prices from around the world. We do not feel strongly about the merits of the index we have chosen, and partners may wish to use another. Whatever the yardstick, we ask only that Nomad be compared over the very long-term. Below, the same pre-fee results are presented in discrete annual increments. In our opinion, it is probably the upper table that is most useful in assessing long-term investment performance.
A US dollar invested in Nomad at inception has grown to be worth $4.16, after fees, as of January 1st, whilst a dollar invested over the same period in the average share, as reflected in the index above, would be worth around $1.56. Put another way, net asset value (i.e. after fees) has compounded at 16.6% per annum, whilst the index has managed 4.9%.
A note on recent performance: please, please, please mentally take the excesses of the good years and apply them to the deficits of the poorer years. In our opinion, this mental trick will help you, and us, make much more rational decisions. This is because it helps to sidestep the Pavlovian response to a sharp change in prices and to sell apparent winners to buy losers or, indeed, the other way around. Zak and I have no influence over the chronological sequence of good years and bad years and we do not trade around our holdings (the practice of trying to outwit short term share price changes and if it goes up, sell a bit; and if it goes down, buy a bit). However, we do expect, through our analysis, to have some influence over Nomad’s destination at the end of a sequence of years. Nomad is about destinations, not smooth routes (no kidding!), and we will have bad years again in the future. Promise. To paraphrase the philosopher William James, the art of being wise is the art of knowing what to overlook. In that spirit, we would suggest you overlook Nomad’s short-term results. We do.
The question then arises: what is a reasonable period to assess performance? To this question we have tended to suggest a period of at least five cumulative years and taking this criteria at its shortest and most recent, Nomad’s gain of 13.2% per annum, all of it earned in the most recent years, is flattered by the paltry alternative 2.4% per annum, offered by the average share. Even this metric may not be that helpful: take that same reading this time last year and the results would show an annual gain of 7.1% for Nomad for the preceding five years (and 2% for the average share). The point is that equity markets have been so volatile that even relatively long-term metrics have been all over the shop. Nomad’s first decade has seen a reasonable crop (19% per annum) from passable ground (5% per annum). We have said it before, but you can’t say these things too often, you do us a great honor by being a patient and understanding hand on the tiller. Thank you for seeing us through a tricky decade for investors in general.
Thank you, also, to those that subscribed to new redeemable shares in August, and to the new partners, welcome. The incremental funding was relatively small, around ten percent of the Partnership, and marks the end of a period, starting in October 2008, when Nomad has been open to subscriptions. Nomad is now firmly closed to subscriptions and Zak’s and my strong preference is for it to remain so. Nomad’s size is now such that, with a following wind, management fees will settle toward a single digit basis point over the next few years (and total stockbroker commissions perhaps less than one basis point!). Whilst we love scale economics shared as a business model, it leads you down the wrong path if you run an investment partnership and are also trying to maximize investment returns! Absent a major swoon in the markets, the odds probably go up from here that our next move will be to return capital, rather than seek subscriptions.
There are two main topics that we would like to discuss in this letter. The first is the level of investment spending taking place at our investee firms. In short, it is huge, and, until very recently, quite in contrast to business behavior at large. Second, the implications of this phenomenon for long-term investors in these businesses. These are important topics and they may be helpful as we think about the evolution of the Partnership over the next few years.
One defining characteristic of the annual reports we have read over the last few years has been management’s resolve to cut costs. Some of the cost cutting has been wise, some perhaps not so, although time will tell. The effect, however, according to the research boutique Empirical Research Partners, is that, during the last year, the level of free cash flow enjoyed by US companies has been as high a proportion of revenues as at any time since at least the early 1950s. The picture outside the US is similar. This is good news and bad. The “free cash flow yield” that can be earned by equity investors, around 8% of market capitalization for much of last year, compared favorably with bond yields, and helped underwrite stock prices. However, one man’s spending is another man’s revenues, and so business activity overall has been depressed. You can’t have it both ways, as it were.
That said, over the last few years our investee firms took a different tack. In contrast to business behavior at large and the intimidating cyclical setting, many of our firms invested heavily. Take, for example, Nomad’s internet retailing businesses, which between them account for close to half of the portfolio: at Amazon.com over the last three years, spending on marketing is up threefold and capital investment on new infrastructure up over fourfold. Note also that these items have grown faster than revenues, which are up two and a half times over the same period. Then there is the subsidy to shipping costs, which have risen threefold, and the continued investment in lowering product prices to the consumer. This investment-in-price-giveback can dwarf other items of investment spending but, by its nature, it is excluded from conventional accounting formats. Its effect, however, can be very real: the saving a consumer would enjoy at Amazon compared to the same basket of goods purchased at a well-run general merchandise chain store will be between approximately 2% and 10% of the total basket price. In other words, Amazon chose to lower revenues by between U$700m and U$3.4bn last year as an investment in hoped-for future customer reciprocation. Including this sum, Amazon will have invested between U$4.8 and U$7.5bn last year, or 14% to 21% of revenues.
It can be argued, quite legitimately, that some of what we have termed “investment spending” here is growth in nature, and some more maintenance (keeping the infrastructure in modern equivalent state). We can all have a guess as to the split between growth and maintenance spending and, if pressed, executives at the firms in question will also have to guess at a split too, as there is no right answer. Even so, we estimate that maintenance spending tends to be a greater proportion of investment spending at high street retailers (all those fixed assets to maintain) or, to invert, there is more genuine growth spending on-line. We would also suggest that investment in price-giveback, so favored by Nomad’s firms, is the most long-lived of the investment spending items if it engenders consumer habit. It may, therefore, be the most valuable to long-term investors. Investment spending like this is a potent force and some internet retailers do it very well. Whatever split one chooses, investment spending at Nomad’s firms has been multiples of their high street rivals in recent times.
Internet firms are often cited as having a capital advantage over traditional businesses, in as much as they require fewer assets to generate a dollar in sales than more traditional businesses. The Achilles heel for internet firms has often come in the form of operating costs, which can be hard to manage, especially at the early, sub-scale stages in a firm’s development. It was this that destroyed the dot com firms a decade ago. It is interesting to note, therefore, that at the established internet retailing firms today, whose revenues are now sizeable, operating costs as a proportion of revenues are less than some main high street chains. In other words, these firms have a capital cost and an operating cost advantage over their rivals. Amazon, for example, has lower operating costs as a proportion of sales than, wait for it, Wal-Mart, a firm sixteen times its size! It is an awesome combination.
Elsewhere in the Partnership, our firms have also invested during the downturn: Michael Page has kept sub-economic offices open whilst rivals have closed theirs, in an attempt to take permanent market share during the recovery; Costco Wholesale has used the decline in real estate values to increase the rate of site purchases for new stores; at Berkshire Hathaway, Warren Buffett has famously placed his “all in wager” on a recovery in the US economy; even at Air Asia, our only sizeable firm to push out its investment plans at all, the delayed delivery of six planes in an order book of one hundred is hardly an indication of real retrenchment.
There are two reasons that our firms have zigged whilst businesses as a whole have zagged. First, Nomad’s firms, by and large, have advantages not enjoyed by the incumbent competition and so have not been subject to the same economic imperatives. Second, their cultures are focused on the customer experience, not on the competition or the profit and loss statement. Our firms tend to chase the vision, not the money.
Before we give the impression that all is rosy in the garden, there is a dark corner of the portfolio, single digit in percentage terms, where the economic reality is troubling. At these firms, revenues continue to decline and encumbered with debt-funded acquisitions from the last boom, the cost cutting has been aggressive to the point of risking future prospects. These firms may be the last man standing, or near last man standing in their fields, but, absent an upturn in their business conditions, it is very hard for them to earn their way to a higher valuation. In short, it is not clear to us that they are in control of their destination, and that troubles us. If we had our time again, we would hope not to be seduced by their (apparent) mathematical cheapness but weigh more heavily their DNA, if you like. One of the things we have learnt over the last few years is that our most profitable insights have come from recognizing the deep reality of some businesses, not from being more contrarian than everyone else. Old habits die hard but, even so, Zak and I are finally attending classes in C.B.A., Cigar Butts Anonymous!
On a weighted basis, weeds included, Nomad’s firms have grown revenues by around thirty percent per annum through the recession. As around two-thirds of Nomad’s firms are deploying a scale economics shared approach to their business (increased revenues begets scale savings begets lower costs begets lower prices begets increased revenues) they may have meaningfully widened the moats that surround their firms in the process. It is quite possible that the recession therefore represented a step change improvement in their competitive positions.
Our inclination, whilst the businesses would appear to have so much ahead of them, is to leave well alone. It would be tempting for Zak and me to do high-fives, claim victory, sell our winners and move on to new investments but, we think, that course of action would be fraught with re-investment risk. Be prepared, therefore, for portfolio turnover to be particularly low for a few years, hence our guestimate for brokerage commissions made earlier.
From our perspective, oddly, this can be hard to do. It is hard due to the human itch to be seen to be doing something, perhaps especially when paid a salary to be doing something. Whilst a lack of buying and selling may look from the outside that we are not doing anything (a Sleep at the wheel, as it were...groan!), the decision not to change the portfolio is an active decision and our research continues as ever. Indeed, we find many great businesses available at what seem sensible prices, but, in our opinion, they do not compare favorably with what we already own, and so we move on, constantly comparing what we have with the alternatives, but often, as far as the portfolio is concerned, doing nothing. When I explained this to an old school friend of mine, who was trained to fly fast jets for the British Military, he said – “Nick, it is really difficult to do nothing, after our training sometimes we would pilot transport planes and the instructors would make us physically sit on our hands to force us to think before doing anything”. If a UK Top Gun needs to sit on his hands, Zak and I may require straightjackets. Or perhaps a really good read (the new annual report season beckons).
Thank you, as always, for your gentle patience,
There is, we are told, a ticket kiosk at a railway station somewhere in India with a sign above the window that reads, “No Bamboozlement Here”. It is in the same spirit that we attempt these cautionary words. Disclaimers boil down to the following statement – if you choose to believe any of this, then you are on your own. Yikes! It will be hard for us to escape this conclusion too, and it makes little sense for us to do anything but disclaim liability for errors, omissions and offer no warranties – please, check everything we say, let us know when we are wrong and forgive our errors. We do promise you this: we are human, we make mistakes, but our mistakes are honest ones. Although we do not intend to mislead, we also cannot guarantee the information in these letters, or that some of our ideas may be interpreted in ways we do not intend. As investors we are trying to do as good a job as we can and we write these letters in good faith to inform and educate Partners on our actions and thinking in the context of the Partnership. We hope that they will be read in the same spirit in which they are written.
Common sense tells you that the price and value of shares can vary greatly, and whilst we do not aim for this, we also recognize that permanent impairment of capital is possible. Our Partnership is concentrated in relatively few investments, perhaps more concentrated than many others, and as such our results will be more volatile than many of our peers. Nomad is also a very long-term Partnership. We do not think it is suitable for investors with time frames less than five years. We also do not think Nomad is suitable for investors overly conflicted with principal-agent issues. If you are at all uncomfortable then, we suspect, Nomad is not for you.
The Nomad Investment Partnership has had two General Partners, Marathon Asset Management for the period from inception in 2001 to September 2006, and Sleep, Zakaria and Company from September 2006 until the present day. Zak and I have been responsible for the investment decisions of the Partnership since inception, formerly as employees of Marathon and then at our own firm, which was set up for the purpose of managing Nomad. The adventure continues...
Some notes on housekeeping (stay awake at the back!)
This is the annual letter and, combined with the interim letter sent to investors in July, is the main format we use to communicate to our Partners. In these letters we have tried to honestly and thoroughly provide all the information we would seek if the tables were turned and we were investors in someone else’s fund. We own shares for very long periods and we are conscious that more frequent or detailed reporting may be unnecessary and even counterproductive. A copy of our magnum opus, the full Collection of Letters, is available upon request from Amanda at Galactic HQ (amanda@sleepzakaria.co.uk). Lots of coffee required. Partners in Nomad will also receive a full copy of our Schedule of Investments by separate post, every six months, which lists all of our investments in detail. In addition, in the Spring you will receive Nomad’s annual accounts, audited by Ernst and Young. Each month statements of account are sent to you by Nomad’s administrator (not us!), Phoenix Financial Services in Dublin, Ireland. Please call Gavin Gray and his team (+353 18 450 8161) with your statement queries. As should taxable US investors as Gavin and his team prepare their tax certificates (1099s) as well.
Clients should always consider Zak and me to be available at the end of the phone, and our (somewhat shabby) front door open to visitors. And whilst we welcome your company, please don’t be too disappointed if we don’t have much that is new to say: we hope it is in the letters already.
Performance numbers are produced by Phoenix Fund Services, Nomad’s administrator, and are audited by Ernst and Young in their annual audit, which follows publication of our letters.
In our letters we refer to both limited partners in the Partnership, and common shareholders in the Nomad Investment Company (feeder fund) as “Partners”. We do this to convey a relationship we seek in which our investors are partners in a shared expe rience and destiny, in which they too have something to contribute. We do not mean to suggest that there is a partnership, in the strict, legal, sense of the word, between the shareholders in the feeder fund and Nomad, or Sleep, Zakaria and Company, Ltd.