Authors: Miles Johnson and Jamie Powell
Sources: Financial Times (https://www.ft.com/content/23590a90-c3b9-481a-aa42-42e553a4670e and https://www.ft.com/content/599e02fc-b051-4f12-8313-c2854d5b76f4)
A few months ago we highlighted in 3 Longs & 3 Shorts the collected newsletters of the incredibly successful Nomad Partnership run by Qais Zakaria and Nicholas Sleep (click here for the newsletters https://marcellus.in/story/the-full-collection-of-the-nomad-investment-partnership-letters-to-partners/). In case you missed reading the newsletters here is why you might want to read them over the Diwali break: “You may not be familiar with the two names — they’re not canon investment figures like Charlie Munger, Joel Greenblatt or Peter Lynch — but their track record is equally as good. During the 12 years the two ran Nomad, to 2013, the fund returned 921.1 per cent, or 18.4 per cent per annum after performance fees.”
As luck it would have it, recently whilst watching other investors sell their Asian Paints holdings after the 2Q results (where Asian Paints announced 30%+ growth volumes & revenues but a drop in operating margins), our mind went back to Nomad’s newsletters. Why? As Miles Johnson of the FT explains in his piece on Nicholas Sleep:
“One idea Mr Sleep helped pioneer is what he dubbed “scale economics shared”. Typically, large companies use economies of scale to raise their own margins and generate greater profits in the short-term for their shareholders. Inspired by his analysis of the US bulk-retailer Costco, Mr Sleep observed that a vast competitive advantage could be achieved by internet companies that opted instead to use their benefits of scale to reduce prices.
This “investment” in their own customers not only lowered prices but also meant that consumers ended up benefiting from these companies’ ongoing expansion. The sacrificing of short-term profits would strengthen what he referred to as the “digital moats” of a new breed of internet businesses.
As Mr Sleep wrote in 2004: “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?”.
Following on from this powerful insight was his argument that modern accounting standards, shaped in an age dominated by capital intensive businesses such as railroads and steel mills, are exceptionally poor at capturing the long-term value created by this sort of approach…To this day many commentators continue to fail to understand why companies that look “expensive” using traditional valuation metrics have continued to surge in value.
Mr Sleep bet big on his observations, putting a very large amount of his fund into Amazon soon after the dotcom bubble when they were trading at less than $30 per share.
Regulatory filings show by 2007 Nomad held 1.4m shares in Amazon, then worth $55.2m. By 2014— the year it closed — Nomad held 2,926,232 shares, worth $1.2bn. Today Amazon trades at above $3,100, and the same position would be worth an eye-watering$9bn. Mr Sleep held on to what he could of his position after Nomad closed. His charitable foundation continues to hold a very large part of its assets in Amazon shares today.”
In a subsequent piece, Jamie Powell of the FT further distilled the insight laid out above in the context of consumer internet companies: “Typically, large companies use economies of scale to raise their own margins and generate greater profits in the short-term for their shareholders. Inspired by his analysis of the US bulk-retailer Costco, Mr Sleep observed that a vast competitive advantage could be achieved by internet companies that opted instead to use their benefits of scale to reduce prices.
This “investment” in their own customers not only lowered prices but also meant that consumers ended up benefiting from these companies’ ongoing expansion. The sacrificing of short-term profits would strengthen what he referred to as the “digital moats” of a new breed of internet businesses.”
Coming back to the Indian market, what companies like Asian Paints and other Marcellus investee companies have done for decades is to do capex through the P&L i.e. they have kept prices low and sacrificed operating margins in the short run when they know the competition will have to take price hikes (and thus sacrifice market share) in order to keep its head above the water. Then by cutting costs and cutting the working capital cycle, our investee companies have recouped the lost margins whilst also gaining market share via the stratagem mentioned in the preceding sentence.
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Note: The above material is neither investment research, nor financial advice. Marcellus does not seek payment for or business from this publication in any shape or form. The information provided is intended for educational purposes only. Marcellus Investment Managers is regulated by the Securities and Exchange Board of India (SEBI) and is also an FME (Non-Retail) with the International Financial Services Centres Authority (IFSCA) as a provider of Portfolio Management Services. Additionally, Marcellus is also registered with US Securities and Exchange Commission (“US SEC”) as an Investment Advisor.
