A letter a day!

Letter #11 June’2009

1.The letter starts with the discussion of Darwin Charles philosophy.

“Darwin knew he was right, but his findings troubled him personally. He was a Christian, in a Christian society, indeed he had considered. studying theology before setting sail on HMS Beagle, and his new ideas challenged the church, his countrymen and his conscience. At major turning points in society, such as he was suggesting, how many of us, we wonder, would be modest about what we had discovered?”

It is an interesting subconscious psychological tendency that truths are often spoken with a whispered voice whilst shaky suppositions are shouted for all to hear. The philosophy of Nomad also was to keep the volumes as low as possible.

“Amazon and Costco do not advertise (no shouting here); Berkshire Hathaway and Games Workshop do not provide earnings guidance (popular with baying fund managers and stockbrokers); Amazon, Costco, AirAsia, Carpetright, and parts of Berkshire give back margin to the customer, we would argue that is a pretty humble strategy too. In other words, around two thirds of the portfolio is invested in firms that in some major way shun commonplace promotional activity and they are no less successful as a result.”

2.Over diversification

It is just that only few big things in life are knwoable and that’s why Nomad has few investments.

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

3.If one is to be a successful long-term investor, is to recognize the sources of enduring business success, get in early and own enough to make a difference. Which raises two questions:

1)what are the sources of success?
2)if these are so readily recognized up front why are they not discounted in prices already?

One of the sources of success according to Nick and Zak is scale economies shared. According to them it is the best business model that works in the long run.

3. Few of the mistakes which investors/fund managers make:

1. Mis-analysis, 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 returns.

“Zak and I call this the Barbie problem, as Mattel has struggled to replicate the economics of its famous doll.”

2. Structural or behavioral: Active fund managers have to look active. One way to do this is to sell Wal-Mart, which appeared expensive (but actually wasn’t), to buy something that appeared cheaper (but err, also wasn’t); investors are not long-term and did not look further than the next few years or, more recently, few quarters.

“Evidence for this can be gleaned from the average holding periods for shares which stands at just a few months; fund managers wish to keep their jobs and espousing a ten-year view on a firm risks being a hostage to fortune; marketing folks require new stories to tell and new stocks in the portfolio provide new stories; fund managers sell their winners in order to appear diversified in the eyes of their clients.”

3)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! Empirical Research Partners, an investment research boutique, discovered that the chance of a growth stock keeping its status as a growth stock for five years is one in five, and for ten years just one in ten. On average, companies fail.”

4.Investors see the information (on conference calls they cheer “great quarter”) but, they incorrectly weigh the information.

“It could be argued that lots of things had to go right for Wal-Mart to grow for forty years. That is certainly true but, at its heart, a very few simple things really mattered. In our opinion, the central engine of success at Wal Mart was a thrift orientation fueling growth with the savings shared with the customer. The culture of the firm celebrated this orientation and reinforced the good behavior. This is the deep reality of the business. This should have had the greatest weighting in the minds of long term investors even if other things looked more important at the time. Instead, investors may place too much emphasis on valuation heuristics, or margin trends, or incremental growth rates in revenues or any of the list above, but these items are transitory and anecdotal in nature.”