-Lachlan Mackay
Cult fund manager Nicholas Sleep has gone under the radar in much of the investment world despite having one of the best track records in recent history. Sleep made important observations over his career that are only just being illuminated among mainstream investors 15 years later. His much sought-after investor letters are rare and offer universally applicable pockets of wisdom. Nowadays, the lessons learned are being applied to the digitally accelerated post-pandemic world we are attempting to solve for, whereby many business models will inevitably be rendered uneconomical and a few others will grow beyond all expectations.
Sleep coined the term “scale economics shared” in reference to Costco’s business model that many investors had failed to properly understand. Costco embodies the term “customer is king” and Sleep’s 2004 analysis found that their strategy of passing the advantages of expanding scale on to customers in further reduced prices (from already highly discounted levels), instead of taking profits themselves, gave the business a long-term compounding power unlike its competitors. His 2004 pitch concluded: “The consensus has it that Costco is a low-margin retailer with an expensive stock and a cost problem. That is certainly one description. But in our judgment it is a cost-disciplined, intellectually honest, high-product-integrity, perpetual motion machine trading at a discount to value.”
This is likewise a commentary on the fallibility of conventional valuation heuristics. Costco were operating with 1.9% margins, around half those of Wal-Mart and Target. They were trading at 24x earnings per share, which was pricey for a big box retailer. Of course, with the benefit of hindsight it is easy to see Sleep was right – Costco shares have grown over 7x since his analysis was published.
In 2007, Sleep noted that his “scale economics shared” model applied to internet retailers as well, who were in an early growth stage and could achieve a vast competitive advantage by opting to use their benefits of scale to reduce prices and service the consumer. Unlike Costco, internet retailers can rapidly add scale with near-zero incremental capital. Today, the dominant retailer is Amazon: fiercely customer-focused with a day 1 growth mentality, selling in bulk and at huge and increasing discounts to competitors. Moreover, under traditional valuation heuristics, Amazon stock has been incredibly expensive for two decades despite consistently outperforming the market’s implied growth expectations.
Sleep’s 2007 Nomad Partnership investor letter noted:
“To those who argue Amazon is large already we ask two questions: What do you think e-commerce will be as a proportion of US retailing in ten years, and what do you think it was last year?
After doubling in the share price and the weighty resultant position in the Partnership it would be easy to claim victory, high five, and sell our shares in Amazon. However, the high weighting makes sense given our understanding of the destination of the business and the probability of reaching that destination. We have argued that the biggest error an investor can make is the sale of a Wal-Mart or a Microsoft in the early stages of a company’s growth. Mathematically this error is far greater than the equivalent sum invested in a firm that goes bankrupt. The industry tends to gloss over this fact, perhaps because opportunity costs go unrecorded in performance records. We wonder, would selling Amazon today be the equivalent mistake of selling Wal-Mart in 1980?”
Indeed, Sleep’s Nomad Partnership held $55.2 million of Amazon shares in 2007, when the stock ended the year trading at 82x earnings. Nomad had more than doubled the size of their holding by the time the Partnership closed in 2014, when the position was worth $1.2 billion. Today, those shares would cost you around $9 billion. For decades, consensus that Amazon is overpriced has been too reliant on misleading heuristics. The cost of missing out has been immense.
Today’s lofty valuations of tech companies lead us to reflect on Sleep’s now-clear observations, which at the time were contrarian views. At Montaka we strive to find high quality businesses with similar long-term advantages, including some that employ Sleep’s “scale economics shared” model. We understand the cost of missing out on today’s 2004 Costco or Amazon far outweighs the cost of overpaying for a traditionally “expensive” business. Fortunately, we avoid such heuristics through independent analysis and a deep understanding of the qualitative aspects of industries that make them attractive on a decade-plus view.
Montaka owns shares in Amazon.
Lachlan Mackay is a Research Analyst with Montaka Global Investments. To learn more about Montaka, please call +612 7202 0100.
