#91 - Culture Eats Strategy (From the Archives)
Nomad Investment Partnership: Investment Selection Criteria
Hi 👋 - Spending a few days in the Great Smoky Mountains, so dipping into the archives this week. The more I learn about business, the more important I think that culture is to successful outcomes. Culture was one of the common traits underpinning investments by Nick Sleep and Qais Zakaria at Nomad Investment Partnership. Here’s a look at the traits they screened for. Thanks for reading.
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All The Small Things
Nomad prospered by doing things others didn’t do. In an industry of specialists, Nick and Zak were generalists. While most mutual funds held stocks for less than a year, they owned stocks for five years. Similarly, Nomad focused heavily on culture in their research and invested in businesses with great character.
Like quality, culture is difficult to measure, but tremendously important. Culture doesn’t fit neatly into a spreadsheet, so it’s easy for investors to avoid or undervalue. To Nomad, this spelled opportunity. As they wrote in their 2005 annual letter:
In the markets investors tend to latch on to what can be measured, aided by the accountants and to some extent by their own laziness. But there is a wealth of information in items expensed by accountants, such as advertising, marketing and research and development, or in items auditors ignore entirely such as product integrity, product life cycles, market share and management character.
To Nomad, culture wasn’t about office happy hours or ping pong tables. It was organic, often engrained at a firm’s beginning. Among other attributes, great character meant attention to detail, frugality, long-term thinking, and management with skin in the game. The right culture influenced employees to make good decisions, day after day. This was incredibly rare and rarity made it valuable.
Nick and Zak were blunt in their assessment that most companies lacked a healthy culture. To Nomad, the opposite of a healthy culture was locker room culture, which focused on winning at all costs. Here, corners would be cut to juice short-term performance or earn higher bonuses. These actions could be detrimental to a business long-term. Rot spreads. In their 2003 mid-year letter, Nomad wrote that:
Value creation is often most sustainable when it is built slowly.
Actions taken to hit quarterly targets at the expense of the future was anathema to Nomad. Knowing that there’s never just one cockroach, Nick and Zak avoided companies with locker room cultures, writing in their 2009 annual letter that:
We have learned or, rather, come to appreciate, that the character of a firm - call it the ability to resist locker room temptation - is far more important than first we realized. This is an important insight. In the long run it may be all that matters.
Be Foxy - The Aggregation of Marginal Gains
The Greek poet Archilochus divided people into two camps: foxes and hedgehogs. Foxes know many things, while hedgehogs know one big thing. Nomad invested in foxes, businesses that did many small things well. Inverting the situation shows why, as illustrated in Nomad’s 2010 mid-year letter:
Take a one-big-thing-firm, such as a drug company, for example. 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...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.
Nomad hunted for companies with durable competitive advantages. Businesses that did many little things well were more robust. No doubt Nassim Nicholas Taleb would agree.
Costco, a staple of Nomad’s portfolio, is a good example. The company does not benefit from cheap real estate or low wages (they made a point to pay above industry averages). Instead, Nomad’s 2010 mid-year report notes:
The firm’s advantage starts with 147,000 employees at 566 warehouses making multiple daily decisions regarding U$68bn worth of annual costs. Its thousands of people caring about thousands of things a little more, perhaps, than may occur at other retailers.
This aggregation of marginal gains compounded, translating into low prices for customers, which kept them coming back for more. Costco’s culture was a durable advantage, driving superior financial results. Its sales per square foot of retailing space were four times higher than a run-of-the-mill supermarket.
The Perfect Model - Scale Economics Shared
Costco is also an example of scale economics shared, a business model that Nomad invested heavily in. As a firm grows, scale savings are given back to the customer through lower prices. This turns size into an asset. Customers reciprocate by buying more which increases scale and allows for further price reductions. The result: a flywheel. While most companies pursue scale efficiencies, few share them with customers. Nomad invested in firms that did like Air Asia, Amazon, and Costco.
To measure a company’s moat, Nomad created the robustness ratio framework. This compares the amount of money consumers save to the amount of money that shareholders earn. For Costco, the ratio was about 5:1 meaning that Costco shoppers saved $5 for every $1 of earnings retained by the company. Nomad invested in companies with high ratios, believing that low prices drove loyalty and repeat purchase behavior, creating profitable long-term relationships (see: Amazon Prime).
Frugality - Counting Pennies
Nomad also valued frugality. In their 2010 mid-year letter, Nick and Zak regale with glee that someone at Amazon took the initiative to remove lightbulbs from vending machines, saving the company $20,000 per year. While they detested frivolous spending, the duo cheered on investments that would drive long-term customer loyalty at the expense of near-term profitability, like price reductions (Amazon and Costco), brand marketing (Estee Lauder), or building out a fulfillment network (Amazon). Because of their long time horizon, Nomad could stomach volatility in stock and financial performance that short-term holders couldn’t.
Companies that took pride in doing the small things right also tended to get the big things right. The duo wrote in their 2012 annual letter that:
Good things follow when you care about the pennies.
Owner Operators - Incentives, Incentives, Incentives
Always keenly attuned to incentives, Nomad had a strong bias towards investing in owner operated companies. For example, in 2008 about 90% of the portfolio was invested in companies where the founder or largest shareholder ran the company.
Nomad, preferred investing in publicly traded firms that were run by managers who thought and behaved like they ran private firms. Jeff Bezos is a prime example. Unlike most CEOs, Bezos doesn’t speak on Amazon’s quarterly earnings calls and he spends very little time courting investors. Instead, he prioritizes Amazon’s long-term strategy and investments.
While finance is a quantitative discipline, Nomad thought deeply about the qualitative aspects of companies. Culture was paramount. The way a company treated its customers and employees, a management team’s time horizon, and the way capital allocation decisions were made all mattered. Nomad’s investment philosophy often bucked industry orthodoxy. The companies they invested in did the same. While the locker room set was intent on winning the quarter, they were focused on winning the next decade. This was a winning strategy.
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Going Deeper
If you’re interested in wading deeper into Nomad’s letters, below are a few suggestions. If you’d like my highlights and notes, give me a shout. Happy to share (full disclosure: they’re 53 pages long). Here are part one and part two of the Nomad series:
2010 Annual Letter. “Investment Spending by Nomad’s Businesses.” How price reductions and other investments are building Amazon’s moat.
2009 Annual Letter. “The Locker Room Culture.” The impact of culture on business performance.
2008 Annual Letter. “Incentives. Incentives. Incentives.” Good discussion of scale economics shared.
2005 Interim Letter. “Measuring the Moat.” An overview of the robustness ratio framework looking at Costco and GEICO.
2004 Annual Letter. “Deconstructing the Business Case for Costco Wholesale.” Costco investment thesis.
