[00:03:25] Kyle Grieve: Welcome to The Investor’s Podcast. I’m your host, Kyle Grieve, and today I have no guest. So there’s one set of fun letters that has significantly impacted many great investors, such as Mohnish Pabrai and Bill Miller, and that is the Nomad Investment Partnership Letters. I’ve read them and I’ve learned a lot of important lessons.

[00:03:41] Kyle Grieve: But when I heard that there was a book written in the similar vein to Warren Buffett’s Ground Rules, I was very, very excited. These compilation style books are so helpful because they get down to the essence of the primary topics that a set of investing letters is really talking about. Now, The Rational Cloner compiled Nick and Zak’s letters and wrote the book, Nick and Zak’s Adventures in Capitalism.

[00:04:00] Kyle Grieve: The book has 40 chapters and part one on important investing concepts. Then, in part two, it discusses some case studies of the businesses that Nick and Zak owned. In today’s episode, we’ll be covering some of the concepts from part one of the book. I’ve chosen just a few of the chapters with the most powerful lessons that I want to share with you.

[00:04:17] Kyle Grieve: But before we get into the specifics, let’s have a look at Nomad’s ground rules. They named about six of them here, okay? So the first one is that we are investing for the long term in modestly valued firms run by management teams who can be making decisions the fruits of which may not be apparent for several years to come.

[00:04:34] Kyle Grieve: Number two, the near term results are likely to be as bad as they are good, but we are confident that in the long run, they will prove satisfactory. Number three, Nomad’s competitive advantage over its peers will come from the capital allocation skills of your manager, if any, and the patience of our investor base.

[00:04:52] Kyle Grieve: Number four, only by looking further out than the short term crowd can we expect to beat them. Number five, it is for this reason we named Nomad an investment partnership and not a fund. The relationship we seek is quite different. And number six, one of Nomad’s key advantages will be the aggregate patience of its investor base.

[00:05:11] Kyle Grieve: Now there’s one significant theme here that really jumps out to me in all of these points, and that’s the concept of time. Namely, the Nomad looked for long term opportunities and investors who were willing to seek long term returns while being willing to accept short term volatility that was inherent into their strategy.

[00:05:30] Kyle Grieve: I think they did a wonderful job of creating the partnership to align incentives in a way that was beneficial for both them and their partners. Now let’s have a look at their partnership structure. Nick and Zak were not in the business of collecting fees by increasing assets under management.

[00:05:45] Kyle Grieve: They did charge a tiny management fee, which was just enough to cover costs, which they kept quite low. Then, they would take a cut of profits above a 6 percent hurdle rate, which was what Buffett did in the Buffett Partnerships. An interesting wrinkle that they did to make things even harder for them to earn was in the event that performance fell short for multiple years.

[00:06:03] Kyle Grieve: To deal with this, they set, quote, aside their performance fees for a few years, and if they fell short of the 6 percent hurdle, they would refund a portion of the previously earned fees to their investors. Buffett Partnerships. Now, the goal of the Nomad Investment Partnership was very simple. And it was to generate large, absolute returns.

[00:06:21] Kyle Grieve: Note how I didn’t say that they wanted to beat the index. The index had no place in their investing and mattered very little to them, which is very contrary to the majority of funds out there. We’ll touch more on this later. The ultimate goal was to turn a dollar into $10. And they wanted to do it utilizing Charlie Munger’s cigar butt style of investing by buying just a few stocks that would be worth holding onto for a multi-year time period.

[00:06:42] Kyle Grieve: And they crushed it on this goal. The partnership ran from 2001 until the end of 2013. During that time, they had annualized returns of over 18 percent after fees. If you invested a dollar in 2001 before fees when the partnership closed, you’d have 10. During the same time, the MSCI World Index returned just 6.5 percent per annum. Another interesting point about the business fee structure was how Nick and Zak thought about the management fee. They said that they would take a salary cut to run Nomad and the plan was that as Nomad kind of scaled up, the management fee would decline as a percentage of assets.

[00:07:17] Kyle Grieve: Therefore, all investors would share in the scale economics of the fund’s continued growth and success. Now let’s get into some details with the types of investment that Nick and Zak were looking for. It’s worth noting here that Nomad’s investing strategy became much more refined over time, kind of like Buffett, although Buffett ended up taking probably a few more years to come to the high quality camp compared to Nick and Zak.

[00:07:38] Kyle Grieve: In the beginning, they look for a business with the three following characteristics. One, it should be currently valued at 50 percent of its intrinsic value. Two, it should be run by owner oriented management and three, it should be employing a long term capital allocation strategy with shareholder wealth as the focus point.

[00:07:56] Kyle Grieve: Now, even as they evolved, I think they’ve still stayed true to these principles, but I think they started adding additional emphasis on a fourth characteristic, which was the search for a business that expressed scale economics shared. In the early days of Nomad, you can find all sorts of cigar butts that they invested in that didn’t really have a lot of the concepts of quality that you would traditionally think of.

[00:08:18] Kyle Grieve: But interestingly, here’s how they viewed the simple math of their holdings according to the 50 percent rule of intrinsic value. Now, I want to go over a little bit of the math here of why they wanted these businesses price to be trading at 50 percent of intrinsic value. So they figured that the business they bought for 50 percent discount would grow with intrinsic value at approximately 10 percent per annum.

[00:08:40] Kyle Grieve: Now, the effect of this over five years would be that the 1 of value would turn into approximately 1. 62 of value. However, since they were buying at a 50 percent discount, they reaped the returns from 0. 50 to 1. 62. Now, this assumes that the company’s price would eventually align with its value. And if it did, you would get a compounded annual growth rate of around 26%.

[00:09:00] Kyle Grieve: But in reality, they knew that they would make mistakes. If all their holdings were flat over that 5 year span, they assumed that their compounded annual growth would amount to about 13%. But this is where the beauty of compounding really comes into play. So Gautam Baid had a really good example of this asymmetry of compounding in his interview with Clay on TIP583.

[00:09:21] Kyle Grieve: Let’s just say that you start with two investments. And let’s say we have 20,000 to split between the two. One compounds at 26 percent annually, and one compounds at negative 26 percent annually. Now, intuition would tell me or other people probably who don’t understand compounding that these really just cancel each other out and that we end up with 20, 000, the same amount that we invested from the beginning.

[00:09:43] Kyle Grieve: But that’s wrong because compounding is asymmetric. The winner turns into about 100,000 and the loser turned into 500. Add these up and you still get a compounded annual growth rate of 18%. Now, another important exercise they did was to track the difference in price and intrinsic value for the portfolio as a whole.

[00:10:00] Kyle Grieve: This was their attempt to portray the price and value differences in the businesses they owned in the portfolio so that their partners best understood what they were trying to do. Another investing topic I find fascinating is how outperformers think about measuring and explaining their performance.

[00:10:14] Kyle Grieve: Warren Buffett said any financial professional should be willing to state unequivocally what he is going to attempt to accomplish and how he proposes to measure the extent to which he gets the job done. I think they did a very good job of explaining this in their fund letters by saying that they wanted to be measured on a compounded basis and on a multi-year total basis.

[00:10:33] Kyle Grieve: They also added that it was likely they would underperform the market at times and overperform the market at other times. They would be more likely to overperform in down markets and underperform in up markets. Kind of similar to what Warren Buffett proposed to his shareholders in the Buffett partnerships.

[00:10:48] Kyle Grieve: Now, a simple way to measure their performance would be in rolling five year increments. They believe that this time span gave more of an accurate view of performance rather than trying to constrict that time horizon and make it shorter and shorter. It’s also worth noting that they did not bother trying to beat the index.

[00:11:04] Kyle Grieve: They knew that trying to beat the index would result in short term thinking, which was something they were not interested in doing. To justify these long term holdings, it usually means you need businesses with long term characteristics. And those are the types of businesses where inactivity is the best course of action.

[00:11:19] Kyle Grieve: It is important to note that it did require some time for them to arrive at the conclusion that holding high quality businesses was the direction that they wanted to go in. For instance, one of their smaller holdings from 2004 was Union Cement, which was the largest Filipino cement company trading at about a quarter of the replacement cost of its assets.

[00:11:36] Kyle Grieve: So it was dirt cheap. They wanted to continue building their position as the price cratered. Shares crashed from 30 cents down to one to two cents, and they began acquiring it around the bottom here. Even though this was a small position, it was taken private at 10 cents a share and they ended up making a very, very good profit.

[00:11:52] Kyle Grieve: But this seems closer to a cigar butt than a quality compounder. And as time went on and they drifted towards inactivity, they realized that inactivity only pairs with quality businesses. They said no investor would argue that inactivity should be paired with low quality businesses. Throughout different renditions of their letters, they discuss the problems associated with inaction in the investing industry.

[00:12:13] Kyle Grieve: Specifically, they discuss why fund managers are forced into action because they are collecting fees and feel required to be overactive. But as they also pointed out, inaction is itself an action. So any investor who chooses to do nothing fiduciary duties of their partners. To emphasize the importance of this concept, they said, our portfolio inaction continues.

[00:12:35] Kyle Grieve: And we are delighted to report that purchase and sale transactions have grinded to a halt. Our expectation is that this is a considerable source of value added. Now Buffett and Munger have been touting the benefits of inactivity for decades, but very few people seem to listen. Nick and Zak agree and think that the primary reason for this is that inactivity requires patience.

[00:12:55] Kyle Grieve: Since inactivity is not usually a feature of success in other fields, it is rarely imitated. Additionally, they say that inactivity is the enemy of high fees. Now they outline four reasons why they drifted towards inactivity. The first reason, they don’t know that much, and it’s easier to have an opinion on many fewer stocks.

[00:13:14] Kyle Grieve: The second reason was that outstanding cultures are more powerful than they had originally realized, and they wanted to hold businesses that had these incredible cultures. The third reason was that inactivity reduced the reinvestment risk when you’re fiddling around with names that maybe you don’t understand as well as what you already own.

[00:13:31] Kyle Grieve: And the last reason was that many of the great businesses during the time that they wrote this were on sale. So this section was written in 2009 during the great financial crisis. During this time, the S&P 500 went from a high of 1, 565 in 2007 down to a low of 676 in 2009. So if you look at some of the biggest holdings that they’re best known for, which was Amazon, Costco, and Berkshire Hathaway, I just want to go over some of the drawdowns that they went through during this time.

[00:13:56] Kyle Grieve: So Amazon had a 64 percent drawdown in 2008, Costco had a 47 percent drawdown in 2009, and Berkshire Hathaway had a 51 percent drawdown in 2009 as well. So the fact that they were already very familiar with these businesses meant that they could just vacuum up shares at very, very attractive prices. Now, I’m not really sure what their cost basis was on these names, you know, I’m not sure how long they were buying them for, you know, for all I know they could still be buying them today, but here are the compound annual returns from these bottoms during the great financial crisis.

[00:14:29] Kyle Grieve: So Amazon has a 31 percent compound annual growth rate from its bottom in 2008, Costco, a 23 percent compound annual growth rate from its bottom in 2009 and Berkshire Hathaway, a 14 percent compound annual growth rate from its bottom in 2009. During the great financial crisis, they wrote, it may not feel like it, but for long term investors, this is the best of the times, not the worst.

[00:14:51] Kyle Grieve: Take art and look to the horizon. I just love the same because it just really gets you focused on looking into the future and not dwelling on the negatives in the present. Now back to the right business models to be an inactive investor. They highlight two wonderful businesses they owned in Costco and Amazon that had just three of the following attributes.

[00:15:10] Kyle Grieve: They were founder led, they had great cultures, and they had a culture that was geared towards cost savings. These two businesses definitely had these qualities in large amounts. While Costco and Google are still great businesses today, they’re no longer founder led, but I still think they have some of the great characteristics of a wonderful business.

[00:15:26] Kyle Grieve: Now the next concept I want to cover is the investment models Nick and Zak searched for. As early as 2004, it looked like they were beginning to understand the power of a business model they really liked, which they named Scale Economics Shared. You probably have a good idea of what scale economies are, but if you need a quick refresher, it’s when a business scales and unit costs decrease.

[00:15:46] Kyle Grieve: But here’s what Nick and Zak said differentiated Scale Economics Shared. As a firm grows in size, scale savings are given back to the customer in the form of lower prices. The customer then reciprocates by purchasing more goods, which provides greater scale for the retailer who passes on the new savings as well.

[00:16:04] Kyle Grieve: Scale economy share has the following flywheel characteristics. Here’s how Sleep outlined it. Increased revenue causes scaled savings. Scaled savings creates lower prices that they can charge to customers and lower prices that customers have to pay makes them want to shop there more, which therefore increases revenue and on and on you go.

[00:16:22] Kyle Grieve: In my co-host William Green’s great book, Richer Wiser Happier, he writes, Once Sleep and Zakaria understood the magic of this one business model, they made it their overriding focus of their fund. The attraction of cigar butts waned, and they concentrated instead on a handful of companies that shared their economies of scale with customers.

[00:16:39] Kyle Grieve: They were acutely aware of how little in life we ever truly know, but they knew that they had uncovered a deep truth. As William pointed out, they most definitely made this business model the focus of their fund. In 2009, they noted that companies in the portfolio with the scale economics shared were the following names.

[00:16:55] Kyle Grieve: Carpetright, Costco, Berkshire Hathaway, Amazon, and AirAsia. These five businesses combined constituted about 60 percent of the partnership. The last point on scale economics shared I’d like to share was an insight into the investing analysis side of things. They noted that when interviewing management, they would often ask very unconventional questions.

[00:17:15] Kyle Grieve: That question was what a manager would do with a windfall in profits. It came up with a few different use cases for windfall profits. One was to just reinvest it into the business. Two was a return cash back to shareholders in the forms of dividends or share buybacks. And three was to give it back to customers.

[00:17:31] Kyle Grieve: They noted that barely anybody focused on point number three, but Costco was a business that did focus on point number three. And if they could find a business that is giving back profits to customers, they knew that they had found themselves a real winner that fit very, very well into this scale economy shared.

[00:17:47] Kyle Grieve: They pointed out that they thought the reason barely any business was doing this was because it just wouldn’t bode that well on Wall Street. But businesses like Costco were conducting its business to raise a probability of long term success, consistently sharing excess profits with its customers, and just not really bothering with caring what Wall Street thought.

[00:18:06] Kyle Grieve: I love this insight, and I can’t say I’ve researched businesses that are explicit about giving back profits to customers. A business that my cohost Clay and I recently discussed was Old Dominion Freightline, which I think has a degree of scaled economies embedded into it, but they aren’t sharing the excess profits directly with customers.

[00:18:21] Kyle Grieve: Instead, they use these excess profits to provide a superior service to competitors without a reduction in price. So one chapter I really enjoyed reading was about the competitive advantages specific to the Nomad partnership compared to other funds or partnerships. So they noted three advantages in investing that Bill Miller has previously outlined.

[00:18:39] Kyle Grieve: One is the analytical edge, two is the informational edge, and three is the psychological edge. Now, while they agreed with this premise, they actually added an additional edge that was very specific to their partnership. And this was the patience of their investor base. Additionally, they believe that they had an edge in the analytical and psychological departments.

[00:18:57] Kyle Grieve: This is a really exciting insight because you rarely read about how a fund can utilize the patience of its investor base to generate excess returns. And it’s kind of easy to see why. With so many investors looking for immediate returns, the draw towards instant gratification is very, very strong. And because of this, a fund manager might have a hard time justifying purchasing a business at a cheap price that may stay cheap for an extended period of time.

[00:19:20] Kyle Grieve: Most sophisticated investors realize that a great business trading for a cheap price actually de risks the investment, but the average investor has a very hard time coming to grips with this statement. So fund managers basically have to try and ride the momentum of stocks moving up in price, even if the price isn’t necessarily attractive.

[00:19:36] Kyle Grieve: Another advantage that Nomad had due to the patient of their shareholder base was the ability to hold cash. It’s been pointed out that cash doesn’t earn a return and therefore being fully invested is a rational decision. While I mostly agree with this, the right investor with a large cash balance or the ability to call cash at a moment’s notice is very powerful.

[00:19:54] Kyle Grieve: If you have the proper fund structure, Nomad had the former structure and their shareholders knew that cash was sitting on the sidelines waiting to be put to good use rather than spent frivolously on whatever stocks were currently in favor in the market. They also noted that Nomad was a partnership.

[00:20:09] Kyle Grieve: They named it a partnership very intentionally because they wanted investors to understand the relationship between the investors and the managers was to be thought of as a genuine relationship where each party succeeds and fails together. Now if I were to invest my own money with somebody else, I would demand that they take part in both the upside and the downside, which very few fund managers tend to do.

[00:20:29] Kyle Grieve: Now I want to take some time here to discuss a concept that I find fascinating that Nick and Zak mention often in the book, which is risk. Much of what they wrote makes me really think of Howard Marks. So Nick and Zak right here, what you are trying to do as an investor is exploit the fact that fewer things will happen than can happen.

[00:20:46] Kyle Grieve: That is exactly what we are trying to do. We spend a considerable portion of our waking hours thinking about how company behavior can make the future more predictable and lower the risk of the investment. Costco’s obsession with sharing scale benefits with the customer make that company’s future much more predictable and less risky than the average business.

[00:21:04] Kyle Grieve: And that is why it is our largest holding. Our smaller holdings are less predictable, but in certain circumstances could do much better as an investment. We are just not sure they will, as their cone of uncertainty has a much greater radius than Costco. Now, there are many concepts from this short passage to go over in more depth.

[00:21:22] Kyle Grieve: The first part, where you are trying to exploit the fact that few things will happen and can happen, sounds exactly like Mark’s. Howard Marks said risk means more things can happen than will happen. It’s a very simple statement, but it’s very true. So you have to appreciate the fact that under any set of circumstances, a variety of outcomes are possible and you should always allow for the vagaries of the future.

[00:21:43] Kyle Grieve: Now I really liked how Nick and Zak weaved this concept of risk into certainty. They said that they spent a lot of time trying to find out if a business was doing what they thought was necessary to increase the probability of reaching a specific destination. I enjoy how they looped it into this concept that they called their cone of uncertainty.

[00:22:00] Kyle Grieve: And once they found a business that was executing at a high level for extended periods, they felt that this cone of uncertainty would get smaller and smaller, which resulted in two main things. One, a de risking of the investment and two, an increased probability of reaching a good destination in the future.

[00:22:14] Kyle Grieve: And this is why I think eventually they just settled on three primary investments, which were Costco, Amazon, and Berkshire Hathaway. My guess is that those three businesses had the smallest cones of uncertainty out of anything that they own in the portfolio. Because of that, they allowed the positions to continue increasing in size, eventually making up a very large portion of the portfolio.

[00:22:32] Kyle Grieve: Now, this is one concept that I’m starting to really appreciate as I spend more and more time researching other great investors. One of my favorite recent examples was from my cohost William Green’s interview with Bruce Berkowitz in Richer, Wiser, Happier 41. In that episode, Bruce Berkowitz discussed his conviction in St. Joe.

[00:22:50] Kyle Grieve: St. Joe makes up an eye popping 82 percent of Bruce’s Fairholme funds. But it hasn’t always been this way. It started at a 3 percent position and grew for a variety of reasons. And he’s allowed it to grow due to his familiarity with the business. It’s pretty clear that once you understand a business at such a higher level than everyone else, then allowing it to grow is probably a very good strategy.

[00:23:10] Kyle Grieve: I will say that getting to this point of understanding will require a lot of work and time. I don’t think you can understand St. Joe like Bruce Berkowitz does in a very short period of time. Even if you were to spend every waking moment thinking about it. The idea has to play out, and you need to continue learning more, looking at different angles, and coming up with views on the business that aren’t widely shared by other investors.

[00:23:31] Kyle Grieve: It’s evident today that Amazon and Costco are wonderful businesses. But I think Nick and Zak realized how wonderful they were a lot earlier than other investors. And they had the patience to allow the thesis to play out while making the decision to not remove these positions from their portfolio just because they thought they might have become optically expensive.

[00:23:48] Kyle Grieve: The final part of the passage I want to discuss regarding risk was portfolio management. While Nick and Zak knew that they might have some positions in the portfolio that would outperform Costco, for instance, they were fine keeping this position size small. Their largest positions were the ones with the highest certainty for success and the lowest possibility of losing money.

[00:24:07] Kyle Grieve: While I think many investors are good at increasing position sizes for businesses with high upside, I think that many investors, including myself, have a harder time dealing with the risk portion. I think using probabilistic thinking is the best way to display this. Thanks. Thanks. Let’s say that we have two investments in our portfolio.

[00:24:24] Kyle Grieve: One has a 70 percent chance of going up 100 and a 30 percent chance of going down 100. So the total expected value of this investment is 40. The second one is a 30 percent chance of going up 200 and a 70 percent chance of going down 200. The total expected value of this investment is negative 80. It’s easy to see the allure of ignoring the risk portion of this equation.

[00:24:45] Kyle Grieve: One investment can make 100, and the other investment can make 200. Now that’s great, but if we ignore risk, then we fail to see that the investment where we make 200 is actually much, much riskier than the one where we make 100. Now, I don’t advocate putting money into investments with negative expected value, but let’s just say, for example, that we have both of these investments in a portfolio.

[00:25:06] Kyle Grieve: Now let’s say we become more and more comfortable with one of these businesses, the first example, and continue to see them executing at a very high level because they’re starting to de risk and because we’re starting to understand the business better and we’re starting to see they’re thinking long term.

[00:25:19] Kyle Grieve: We see that the chances, the probability of losing money is actually coming down. Maybe the chance of losing 100 goes from the 30 percent chance all the way down to 10%. At this point, the expected value of the investment is so high that it makes a lot of sense to put a substantial amount of money into the idea.

[00:25:35] Kyle Grieve: And Warren Buffett would agree. He said, so I would say for anyone working with normal capital who really knows the businesses that they have gotten into, six is plenty, and I would probably put half of it into what I like best. Now, speaking of your best loved idea, Nick and Zak had some interesting takes on the one bias they continually sought to fight to help them optimize their decision making.

[00:25:54] Kyle Grieve: The bias that they tried to fight against was commitment bias. So they said that in investing commitment bias occurs when we publicly disclose our positions, which most definitely affects our objectivity towards the position. This is a really interesting notion in today’s age where sharing information, ideas, and investments has become pretty widespread.

[00:26:12] Kyle Grieve: People enjoy sharing ideas and I don’t think sharing an idea has some sort of harmful ulterior motive. I think people like sharing for a variety of reasons. It helps you become part of a community of other investors who share the investment that you have. It helps spread awareness about maybe investments that are undiscovered by larger swaths of people.

[00:26:32] Kyle Grieve: It allows you to find other investors who might already be invested in the name and who can share information that maybe you can’t easily come across. And lastly, it just opens up conversations on the business and people love talking about the businesses that they own. And that’s all well and good, but the problem can arise when you fail to get any conflicting information that doesn’t confirm what you already know.

[00:26:53] Kyle Grieve: Social media can be a pretty brutal space. But often, people who follow you on something like Twitter aren’t following you because they want to argue about stocks. They follow you because they want ideas, and generally, those are long ideas. So sharing ideas on Twitter usually means you get other people joining you in the bullishness that you already have.

[00:27:10] Kyle Grieve: Here’s what Munger said on this exact subject in the lens of post-secondary educational institutions. If you make public disclosure of your conclusions, you’re pounding into your own head. Many of these students that are screaming at us, they aren’t convincing us, but they are forming mental chains for themselves.

[00:27:25] Kyle Grieve: Because what they are shouting out, they are pounding in. And I think that educational institutions that create a climate where too much of that goes on are, in a fundamental sense, they are irresponsible institutions. Now, the key term here is what they are shouting out, they are pounding in. Here’s how Nomad Thought fund managers should approach the problem of commitment bias.

[00:27:44] Kyle Grieve: Our thinking is that fund managers should have absolute conviction on the philosophy and methodology of their investment principles, providing of course that those principles reflect reality. But they should be circumspect about expressing these tenets as they relate to individual stocks. Evangelism is not healthy.

[00:28:02] Kyle Grieve: The reason is that whilst fund managers have it in their power to control the way they think, they are unable to control how their companies behave. Businesses evolve, companies make mistakes, business managers change their minds, share prices depart from reality. The investment manager can control none of these factors but needs to assess objectively each one for the risk of misc analysis.

[00:28:24] Kyle Grieve: Now the whole point here is just that you must be willing to combat commitment bias by allowing yourself to walk away from an idea. When you share an idea publicly, it can be harder to walk away from as it becomes embedded into your identity. I think it’s intelligent never to let this happen. Wonderful businesses die all the time.

[00:28:40] Kyle Grieve: Just look at some of the darling stocks that were part of the nifty 50 index from the 60s and 70s. You got Eastman Kodak, you got Sears, you got Xerox. These were all wonderful businesses that at one time were thought to be so good that no price was too expensive to pay for them. Well, that didn’t turn out very well, and the investors who committed to those ideas would have been crushed by the market as the fundamentals of those businesses shifted to the downside.

[00:29:02] Kyle Grieve: So if you share ideas, permit yourself to change your mind and never allow an idea to become part of your identity. Otherwise, I think you risk biases like commitment bias to really expose you to excessive amounts of risk. Now let’s transition here and chat briefly about how Nomad approaches position sizing and diversification.

[00:29:17] Kyle Grieve: Like many high performing money managers, they were concentrated in just a few positions. Nomad. The Rational Cloner noted the average around 10 positions, so they were quite concentrated. But if you go back to June 2009, they had about 20 positions, so I think that’s still quite concentrated. But if you looked at 10 of those positions, they were 80 percent of the portfolio, so they had quite a few of these, you know, kind of smaller tracking positions.

[00:29:40] Kyle Grieve: And during that time, one position made up an astounding 30 percent of the portfolio. Now the book’s author and I agree that the thought process through these levels of concentration made a lot of sense for Nomad. Because they spent so much time thinking about just a few ideas, it made sense to really concentrate their assets on the ideas that they had the highest conviction in.

[00:29:58] Kyle Grieve: Doing this would also reduce risk and not increase it as standard investing dogma would suggest. Only Nick and Zak were running the firm, not an army of helpers. So understanding many ideas in depth was just not possible. So I think they made the rational choice to concentrate their assets on positions that they had the highest certainty on.

[00:30:15] Kyle Grieve: They had a very, very good quote on diversification and parenting that I thought was very insightful. Parents will understand when I say when children are born, they seem to bring their own love with them. However, stocks are not like children. The more stocks you own, the less you care about each one individually.

[00:30:33] Kyle Grieve: Now, I can personally attest to this on the diversification front. The more assets you own, the less you care about each one individually. I think this is a really good heuristic that can really help you decide when it might be time to part ways with a position. Throughout the years, I’ve had businesses where getting through earnings call was just a slog, and I derived very little joy from following along with the business.

[00:30:53] Kyle Grieve: This doesn’t always have to even do with the stock performance going up or down either. Sometimes the business fundamentals are just starting to unravel. And I think using your gut instinct can be an intelligent decision. One example from 2023 was in mode, a business that I think was pretty good, but had mediocre capital allocators running the show.

[00:31:10] Kyle Grieve: Now I wanted to see something in their annual call regarding capital allocation, but I just didn’t see it. So I parted ways with the business and I haven’t regretted it since this was a business that compounded my capital very well, but I just didn’t feel right about the management team. One last point I wanted to mention here about concentration is that it either works very well or very poorly.

[00:31:28] Kyle Grieve: And if you’re a concentrated investor, you better be willing to live with volatility because you will experience it in very high quantities. So, if you’re the type of investor who can’t stand seeing your portfolio go down significantly without selling holdings, you’re much better off diversifying because the concentrated approach will probably do more harm than good for you.

[00:31:46] Kyle Grieve: Now, one theme that comes up often in this book is that investing is simple, but not easy. The Rational Cloner writes that honest, simple, long term investing is unexciting. I think this aligns very well with one of Mohnish Pabrai’s favorite sayings that you will make a very good investor if you enjoy watching paint dry.

[00:32:03] Kyle Grieve: But what is it about investing that is unexciting that Nomad was able to leverage to outperform the market for all those years? There are a few. Nomad gave themselves four choices of where they wanted to invest. They could either add to existing holdings, invest in new firms, invest in growth businesses, or invest in cigar butts.

[00:32:20] Kyle Grieve: They much preferred adding to existing holdings. And the reasoning was simple. They thought many of the businesses they already held had long growth runways. So adding to these businesses would be a great choice versus alternatives, given the depth of their understanding on the businesses that they already knew and owned.

[00:32:35] Kyle Grieve: Secondly, they ignored industry dogma. Third, they did a lot of homework, and they believed there was almost no competition for long term investors who are willing to put in a lot of research, time, and thinking into an investment. And lastly, since they traversed the less traveled road, they found themselves surrounded by very, very little company.

[00:32:53] Kyle Grieve: In my investing journey, I find that it’s getting easier and easier to focus on names that I already own. I continue to add to current positions, averaging up opportunistically. Mohnish Pabrai once used the analogy of a museum for his portfolio, and I think it’s a great one. I’d rather continue to highlight what I already own and know very well, rather than maybe bringing in a new piece of art that I might not like very much.

[00:33:14] Kyle Grieve: This strategy, again, will only work if you’re a long term investor. A wonderful business is like a great piece of art. It will become more and more valuable with age. Another investing insight from this chapter on simple, but not easy was Nomad’s emphasis on keeping portfolio wide metrics. Now I think this is a great mental model for treating your portfolio as a kind of its own conglomerate business.

[00:33:35] Kyle Grieve: So Nomad tracked a few different things that were portfolio wide. They looked at the weighted average revenue growth, which in 2011 was over 30 percent per annum, which if you compare that to other people’s portfolio or the index is going to be at a much, much higher growth rate. They looked at price to value ratio, which basically showed the price of their portfolio versus the current value they assigned to the total portfolio.

[00:33:57] Kyle Grieve: So they would do this as a percentage, you know, they would say at this point in time, the net asset value is X and the value that they saw was Y and then they would just divide it. So you would get like, I remember one point them saying that they had a price to value ratio of 60%. So that means that they thought that their portfolio was obviously very much undervalued by the market.

[00:34:17] Kyle Grieve: And then lastly, they’d like to track return on invested capital. And they noted that return on invested capital was about double in the firms that they owned versus their firm’s competitors. So tracking these kinds of portfolio wide metrics is a great way to observe how your portfolio is differentiated from the market.

[00:34:33] Kyle Grieve: Another metric that they used on a few individual holdings was what they call the robustness ratio. The robustness ratio measures how much a customer saves versus the amount earned by shareholders. Let’s give an example here. If a customer saves 5 and a shareholder earns 5, the ratio would be 1 to 1.

[00:34:51] Kyle Grieve: This is the ratio that they thought that Geico had. But Costco had an insanely high robustness ratio of about 5 to 1. I think it’s important here to talk a little bit about the genesis of this mental model. It came from reading the 2005 Berkshire Hathaway Annual Report. So Nick and Zak Wright, one paragraph stood out for us as Warren Buffett referred in passing to the Division of Operating and Underwriting Cost Savings at Motor Insurer Geico.

[00:35:15] Kyle Grieve: These benefits were divided between shareholders, policyholders, and employees, and the statistics spelt out in some detail. This simple breakdown struck a chord with our continuing analysis of Costco, a significant marathon holding in the United States. What is becoming clearer in our minds is that one can empirically measure the strength of a business franchise through such an analysis of the division of benefits, what we have come to call its robustness ratio.

[00:35:41] Kyle Grieve: Nick and Zak believe that firms with a very high robustness ratio actually increase the strength of their moat. When looking at the Costco example, it’s pretty hard to argue the accuracy of this premise. As Costco scaled up, they were able to save more and more money for their customers. It would have been interesting to see if Nomad tracked how Costco’s robustness ratio grew over time.

[00:36:00] Kyle Grieve: I wonder if they kept it at that 5 to 1 ratio. Or if that number scaled up from a smaller robustness ratio when they first started. Additionally, it would be interesting to know what the robustness ratio is today. While this robustness ratio worked very well for Nomad, I think that its use case isn’t very wide reaching unless you are looking specifically for scale economy share type businesses.

[00:36:22] Kyle Grieve: If you are looking for them, then you probably should be learning about this number and probably get a very good view of whether a company is improving its moat by using the robustness ratio. If a business continues to save its customers more and more money, its relationship with its customers will only improve.

[00:36:36] Kyle Grieve: And that’s a very, very strong competitive advantage to have. Now, if you’re looking to understand the robustness ratio a little more, Nomad gave a few interesting tidbits of information. It makes sense for the early development of a firm to reward customers disproportionately to get more referrals and repeat business.

[00:36:52] Kyle Grieve: Therefore, they thought that actually newer businesses should have a higher robustness ratio. Now, as the same business started to evolve and get a little more mature, the proportion of the robustness ratio going to the customer could decrease and going to the shareholder could increase. But it’s very important that you didn’t take too much of a proportion going to shareholders, because if you did that it could obviously have negative effects on the relationship that a business has with its customers.

[00:37:19] Kyle Grieve: And if a customer’s relationship with the business starts getting weaker, that’s probably going to erode the business’s mode. Now, the problem is that capital markets want increased profits. That was what everyone’s looking for. So businesses are going to be tempted to lower the robustness ratio to appease shareholders and increase the amount of earnings that they can show on their income statement.

[00:37:37] Kyle Grieve: Now, I think a really good example of this is in some of the ride sharing businesses. Many of these businesses were giving massive subsidies to acquire new users. This helped build relationships with customers optically. However, once these subsidies were removed, the actual stickiness of the company customer relationship was revealed and it was very, very weak.

[00:37:56] Kyle Grieve: The other problem with giving too much back to the customer is that some businesses operate at losses for many years while trying to grow revenue and then plan on using some sort of operating leverage in the future to help generate profits. While this looks good on paper, it’s much harder to accomplish in reality.

[00:38:12] Kyle Grieve: This is why I personally prefer to buy businesses that have already solved the profitability equation. It doesn’t require me to take a leap of faith for the investment to work out. Now, I did want to mention here, Amazon, I realized that Bill Miller and Nick and Zak were very early with Amazon and they understood the business far earlier than everyone.

[00:38:31] Kyle Grieve: Even when Amazon was, you know, a loss making company. If you take that approach to investing and never looking at businesses that are profitable, you’re going to miss out on a business like Amazon. And to that, I say, yeah, that’s perfectly fine. I’m going to miss tons of investments. I’m perfectly fine with that.

[00:38:44] Kyle Grieve: I’d rather Investing in a company that I understand very well. If I was looking at a business and I thought I understood it super well, and I understood the future operating leverage of the business, then perhaps I would change my mind and look at a loss making business. But for now I like the strategy that I’m running.

[00:38:58] Kyle Grieve: And I think that many other great investors, I know Chris Mayer is very similar in that he just looks at profitable businesses cause he doesn’t want to have to guess. If the business is going to be profitable in the future. Now, the point here about the robustness ratio, I think ties in surprisingly well with the next chapter I want to talk about, which is incentives.

[00:39:14] Kyle Grieve: If a business is trying to draw customers in with reduced prices to get them to also buy products or services at regular prices, The incentives are just misaligned. This behavior incentivizes a customer to shop around for the best deal, not to stay loyal. And this is just not a winning business strategy.

[00:39:31] Kyle Grieve: To attract new customers, Nomad uses Costco’s effective strategy of giving everyday discounts that don’t fluctuate. In the incentive chapter, they discuss two overarching aspects. One, what incentives do they look for in firms whose stock they wish to buy? And two, how they structured Nomad to incentivize Nick and Zak to continue creating value for their partners.

[00:39:51] Kyle Grieve: Now, I think I’ve already discussed point two here enough, so we’ll focus on the first point. From an incentive perspective, what characteristics were Nomad looking for in potential investments? They were looking for businesses incentivized to raise the probability of a favorable destination. We’ll be getting into destination analysis here shortly, but I really love how they framed the question of incentives to weave it into arriving at a favorable destination.

[00:40:14] Kyle Grieve: In Nomad’s case, since they were focused on scale economy shared, they wanted their businesses to be incentivized to strengthen the business model. So they looked for firms that were incentivizing customers to continue doing business with them, like Costco. They were also looking for firms that could intelligently cut costs to prevent competitors from competing due to prohibitively expensive unit economics, such as AirAsia.

[00:40:35] Kyle Grieve: And then they were looking for businesses that could thrive through economic turmoil. And a great example of this is Amazon. Now let’s chat more about destination analysis, which might be one of the book’s most important mental models. First, what is destination analysis? It was basically how Nomad analyzed their businesses with a focus on the future.

[00:40:55] Kyle Grieve: Looking at a business’s future destination helped them best understand the company’s DNA. So some of the questions they would ask included, What is the intended destination for this business in 10 to 20 years? What should management be doing today to raise the probability of arriving at that destination?

[00:41:10] Kyle Grieve: What could prevent the company from reaching its favorable destination? Now I’ve spent considerable amount of time thinking about a destination analysis. It’s a great tool to help you think about a business using a long term view. A few additional checklist questions I would ask that were outlined in Richard Weiser Happier were, does the company have a healthy internal and external relationships that won’t jeopardize the destination?

[00:41:32] Kyle Grieve: Can executives put their feet up on a desk and allow business to come to them? And is the business riding short term tailwinds that make it look better than reality would suggest? The fascinating part about destination analysis is that it has multiple use cases. Yes, you can use it on individual companies to help you identify likely long term winners.

[00:41:50] Kyle Grieve: However, you can also use lessons from destination analysis from the past to help you guide your decision making in the present and in the future. Nick and Zak even mentioned that their performance in 2007 resulted from some of the mistakes that they learned in 2003 2004. This scenario makes me think a lot about the importance of See’s Candy to Berkshire Hathaway’s success.

[00:42:10] Kyle Grieve: See’s Candy showed Warren and Charlie the strength of a brand moat, which helped them identify some of their greatest investments, like Coca Cola and Apple. In a world of limited information, I think it’s really important to use lessons that you’ve already lived through to help guide you in the future.

[00:42:25] Kyle Grieve: You’ll make fewer errors, you’ll find very, very interesting connections that other people aren’t making, and you’ll find business models that you’re naturally attracted to and just understand really, really well. Now sticking with the theme of Buffett and Munger, Nick and Zak write, let’s invert for a moment when we think of our investee companies.

[00:42:41] Kyle Grieve: The firms which we would quite happily own with no word from them for a few years are those businesses in which we have the highest confidence of reaching a favorable destination. They are the firms we think we know will work. They are also the largest holdings in Nomad. It is the less certain businesses about which we are more insecure that appear to demand more regular attention.

[00:43:03] Kyle Grieve: The next subject I’d like to discuss is mistakes. Nick and Zak had a very good self-awareness of the mistakes that they were likely to make or observed others making or had themselves made in the past. They mentioned that noticing mistakes is a huge advantage but is so rarely done. They listed four mistakes that they found to be most powerful.

[00:43:22] Kyle Grieve: The first one’s denial, which is basically distorting reality to avoid pain. Charlie Munger had a really good example of this in the psychology of human misjudgments where he spoke about a mother during World War II who chose to believe that her son was missing at sea rather than dealing with the pain of just admitting to herself that her son had probably perished on a boat during World War II.

[00:43:44] Kyle Grieve: The second one here is anchoring bias, which is relying too heavily on information early in the decision making process. The third one is drift, and this is how small incremental changes in thinking can lead to larger mistakes. And the fourth one here is judging, which is excessive condemnation or exalting, which stops rational thought.

[00:44:02] Kyle Grieve: I think this is similar to the hating and loving biases that Munger aligned in his talk on the psychology of human misjudgments. Now these are really potent mistakes to consider regularly or you risk making them yourself. And I think we will all make these mistakes in the future, even if we are aware of them to some extent.

[00:44:18] Kyle Grieve: But I think it’s just an excellent exercise to actively think about the mistakes you could be making, which will hopefully improve your decision making. Anchoring bias has been a problem for me when adding to current positions. I remember I’d be anchored to my initial buy price for a holding and tell myself that I’d never buy above that price if I wanted to add to that position.

[00:44:36] Kyle Grieve: Well, that makes sense for me. Garba businesses that are unlikely to show much improvement in the fundamentals of the business. However, a good quality compounder is going to continue increasing an intrinsic value. So if you anchor yourself to your original cost basis, and you do an excellent job of picking the right stock, you’ll end up with a small position that you’ll never be able to add to.

[00:44:57] Kyle Grieve: Even though the business is the exact type of business that you want to own a relatively concentrated position in. So I have a really good example of this, which was with the Aritzia. So I had originally Aritzia at the start of COVID 19 back in 2020. My first tranche was priced around 16 and from there, the stock soared to around 60.

[00:45:15] Kyle Grieve: I was perfectly fine. Not adding there as it just seemed to be well, well above intrinsic value. But over time, the stock got less and less love from the market as the COVID induced growth rates that had propelled a lot of that upward movement in the share price and in fundamentals just started receding and, you know, more normalized growth started showing its face.

[00:45:36] Kyle Grieve: Now I knew that I wanted to add to the position, but I wanted to add more below 16 and it just wasn’t looking like that was going to ever happen. But in 2023, I realized that the business had gotten much better than when I first bought it. And it was just really silly of me to anchor to that original price.

[00:45:53] Kyle Grieve: And I just wanted to share with you a couple of things that I should have been really focusing on to understand that the business was worth more. So the retail revenue doubled for the business. Then when you look at the e commerce side, e commerce revenue, nearly quadrupled now, a big part of the expansion plans for Aritzia is expanding into the U S and during that time, between when I first bought in 2023, U.S revenue had quadrupled.

[00:46:17] Kyle Grieve: So clearly the growth story in the U S is going very, very well. And then just to add more fuel to that, the U S store account went from 29 to 51. And then additionally, the business had been spending a lot of cash on the expansion of its distribution centers. So when I realized that I was anchor bias, the business was punished for its expansion plans and the fact that it had spent a couple hundred million on capital expenditures.

[00:46:39] Kyle Grieve: I took the opportunity to overcome my bias and buy more in the thirties and a lot more in the twenties, and it’s done very well for me since now, an interesting trick that Nomad uses to help smooth out performance and avoid biases is to rearrange performance by year. For instance, let’s say your performance over a five year period is 21%, 43% minus 16%, 0%, and 28%.

[00:47:01] Kyle Grieve: With these numbers, you will have compounded your money at 13% per annum. Now, let’s say we rearrange these numbers in a thought experiment. And we make it go in order of a negative 16%, zero percent, 21%, 28%, and 43%. We still end up with the same amount of money at the end of five years. Sure. You’ll go through some pain in those first two years of no gains, but you can take solace in the fact that you’re in line for some positive regression to the mean.

[00:47:27] Kyle Grieve: This is just an excellent thought experiment to help you really stay resilient throughout the bad years that I think will inevitably befall literally all investors. Now to cap this episode off, I want to share a summary of a couple of my biggest takeaways. The first one here is that patience is crucial for investing performance.

[00:47:44] Kyle Grieve: The businesses you own may make decisions that will take years to come to fruition. If you buy a business because of its long term thinking, don’t make the mistake of selling as a punishment for its long term orientation. Now using that example I just gave above about Aritzia is literally exactly what happened here.

[00:48:00] Kyle Grieve: The market did not like the fact that Aritzia’s cash flows had decreased significantly and gone negative. But the fact is, is Aritzia had said that they were going to spend a lot of money expanding the business, which is necessary for the further expansion plans into the U. S. So essentially the market was punishing Aritzia short term cash flows for trying to grow long term.

[00:48:21] Kyle Grieve: So the second takeaway here is that performance will be volatile, especially while running a concentrated portfolio. So I think you need to learn to live with it. Use the thought experiment I just discussed about reorienting your returns to note that the end result will still come to fruition, even if you have some down years.

[00:48:37] Kyle Grieve: And the beautiful part about it is that if you have a really big down year, a lot of the times the next year is going to be really, really good. Obviously, that’s not a guarantee and you know, things can happen, but from my experience that that’s kind of what has happened. And from looking at the results of other great investors, that tends to happen as well.

[00:48:52] Kyle Grieve: Now, my third takeaway here is that being a lazy investor whose primary activity is inactivity only works with high quality businesses. If you like chasing shorter term opportunities, that’s perfectly fine, but just realize that you cannot sit back and do nothing for extended periods of time. Now, if you look at the early days of the Buffett partnerships, Buffett had a couple of different buckets of investments.

[00:49:14] Kyle Grieve: He had some that he wanted to hold for a shorter period of time and some that he wanted to hold for longer periods of time. So you have to understand that he had to kind of reorient his thinking process based on the bucket that the investment is in. So don’t just blankly put everything into a long term bucket when there’s.

[00:49:31] Kyle Grieve: Clearly investments that are going to be very, very short term because you’ll end up hurting yourself pretty badly. And my fourth takeaway here is that fighting commitment bias is definitely a battle worth undertaking. Be aware of sharing your ideas with other people or a large audience. I think it’s perfectly fine.

[00:49:45] Kyle Grieve: I do it. And I enjoy it because I get a lot of pushback from people about what I’m trying to learn about and maybe some gray areas in my thinking process, maybe areas that I could be wrong on. But I really think it’s really, really important to avoid allowing a stock to really become part of your identity where removing your commitment bias just becomes harder and harder.

[00:50:05] Kyle Grieve: Instead of concentrating your capital on the highest upside opportunities, concentrate on the businesses with the highest certainty of success. I think doing this locks in two things. One, it locks in the certainty that will hopefully increase over time that the business will reach a favorable destination in the future.

[00:50:21] Kyle Grieve: And then secondly, I think it just decreases risk. I mean, if your chance of losing money goes from 50 percent down to 40, 30, 20, 10%, that means that the investment is getting better and better. It probably means that the investment has a stronger and stronger moat. And then lastly, you know, on concentration here, just look at Warren and Charlie.

[00:50:38] Kyle Grieve: I mean, Warren, 99 percent of his wealth is in one stock and he’s done very, very well. And Charlie just had a few stocks, but he also did very, very well with a concentrated approach. That’s all I got for you today. Thank you so much for tuning into my episode. If you want to connect with me on X, please follow me @IrrationalMrkts or add me on LinkedIn.

[00:50:57] Kyle Grieve: I’m always striving to increase the quality and value of each episode that I release. So please feel free to provide me with feedback of both the positive and negative variety so I can help enrich your listening experience. Have a good one.

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