Nick & Zak's Terminal Portfolio
"This is where we want to go."
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I recently started to dig into a collection of Nick Sleep and Qais Zakaria’s semi-annual letters written during their time atop Nomad Investment Partnership — and, wow, they’re terrific.
It’s always a treat to come across money managers with a Buffett-like knack for breaking down complex investment ideas into digestible (and witty) lessons.
Importantly, Nick and Zak also knew how to put points on the board. Or, more accurately, put increasingly large sums of money into their partners’ pockets. Nomad crushed the wider market in its thirteen years of operation — achieving a 921.1% cumulative return since inception on September 10, 2001 — which catapulted the duo up into rarefied air.
But not, necessarily, fame. The Nomad duo kept a very, very low profile — though they popped their heads up long enough to be profiled in William Green’s excellent Richer, Wiser, Happier. (A must-read chapter in a must-read book.)
After winding down Nomad in 2014, Nick and Zak again echoed Buffett by returning their winnings (and time) to society through charitable causes. Sleep created The I.G.Y. Foundation, which focuses on “rationally and quietly re-allocating capital to where it can do the most good”. It’s also the digital home of the Nomad letters.
The history, performance, and ethos of Nomad Investment Partnership deserves serious study. (And I hope to do just that, here, in the future.)
But, for the time being, my focus lies elsewhere. On an offhand comment in one of the earliest Nomad letters, in which Nick and Zak mention their “terminal portfolio”…
The Terminal Portfolio
In 2004, Nick Sleep and Qais Zakaria wrote:
In the office, we keep a list of companies assembled under the title “super high-quality thinkers”. This is not an easy club to join … Entry is reserved for the intellectually honest and economically rational, but that alone is not enough. There are many companies that do the right thing when their backs are against the wall, and this list excludes those temporarily attending church. The anointed few are there because they have chosen to out-think their competition and allocate capital over many years with discipline to reinforce their firm’s competitive advantage.
The “super high-quality thinkers” are our best guess of those firms whose shareholders could abdicate their right to trade stock, sure in the knowledge that their capital will be well-allocated for years to come within the businesses. This list is a group of wonderful, honestly-run compounding machines. We call this the “terminal portfolio”. This is where we want to go.
Their words evoke Warren Buffett’s famous warning to only invest in companies that you would feel comfortable owning if the stock market closed down for five years. Only the most honest, well-run, dominant businesses can provide that kind of peace of mind. These are the companies that everyone should aim to own in their portfolios.
Of course, that’s easier said than done.
Companies with such sterling attributes rarely sell at attractive prices.
Ah, but that’s where the word “terminal” comes in.
Nick and Zak aren’t talking about companies that they’re buying today, tomorrow, or next week. But, rather, those select few “compounding machines” that they hope to get their hands on someday in the future — likely as permanent holdings — even if their current valuations seem out of whack.
The Nomad gents recognized a simple truth: Prices change. Even for the very best companies with the very best business models. The high-flyers of today will, no doubt, drop in the future as Mr. Market cycles through his various moods.
Too often, investment decisions are rushed by the whims of Wall Street. A particular stock gets pummeled down in price and investors, sensing a fleeting opportunity, frantically research the company in question before this “bargain” slips away.
Such a race against the clock is not exactly conducive to rational decision-making.
It’s the intelligent investor’s job to be ready. And the careful creation of a terminal portfolio — in advance — will ensure that he or she is.
What is the probability that, say, over the next ten years, a good portion of these “super high-quality thinkers” will be priced at fifty cents [on the dollar]? Our betting is that the odds are reasonable. Even though prices are generally high, the trick is to do the work today — so that we are ready [when prices fall].
Your terminal portfolio is a wishlist with a purpose. It’s aspirational, sure, but also an opportunity to research and study your dream companies.
Set valuations aside for a moment (heaven forfend!) and ask yourself:
What does my ideal stock portfolio look like?
Which companies would I like to own forever?
Which business models are built to last?
Which companies behave well because they want to, not because they have to?
Which companies have built a “seamless web of deserved trust” between management and shareholders?
What stocks would I own even if the market was closed for years at a time?
Bam — there’s your terminal portfolio.
(Or, at least, the start of one. Some picks may fall by the wayside as you research these companies and ruthlessly cull out the weak links. Remember: Nick and Zak had just fifteen names in their own terminal portfolio. Companies must walk a straight and narrow path before being allowed membership in this uber-exclusive club.)
As Nick and Zak say, “This is where [you] want to go.”
Nomad’s Shining Star: Costco Wholesale Corp.
In letter after letter, Nick Sleep and Qais Zakaria kindly highlighted how one company — in particular — exemplified everything they were looking for in a “super high-quality thinker”. (Hint: Charlie Munger would approve.)
Costco was one of Nomad’s earliest — and largest — investments. Nick and Zak eagerly scooped up shares when others soured on the company due to its razor-thin margins and rising costs.
(The costs were a legitimate concern, but tiny margins are kind of Costco’s whole point. What Wall Street missed was that COST 0.00%↑ used its impossibly low prices to dig an impregnable moat.)
Whenever Costco discovered some new way to reduce costs, it passed those savings straight on through to the customer. Thereby entrenching its competitive advantage that little bit more. Nomad coined this the “scale efficiencies shared” business model.
According to Nick and Zak:
[Costco has] a very simple and honest customer proposition in the sense that the membership fee buys the customer’s loyalty (and is almost all profit) and Costco, in exchange, sells goods whilst just covering operating costs. In addition, by sticking to a standard mark-up, savings achieved through purchasing or scale are returned to the customer in the form of lower prices, which in turn encourages growth and extends scale advantages. This is retail’s version of perpetual motion.
More like a perpetual motion virtuous cycle.
Membership numbers keep increasing because of Costco’s famously-low prices, which leads to both profits for Costco and reduced costs from additional scale advantages, which Costco then uses to lower prices even more, which attracts more members, etc.
Rinse and repeat. Everyone wins.
As Munger said in his Redlands Forum Q&A, a “win-win [deal] is the only formula that really will work on and on and on”.
More from Nomad:
In the center of [this] model is a paradox: the company grows through giving more back. We often ask companies what they would do with windfall profits … Almost no one replies, “Give it back to customers.” How would that go down with Wall Street? That is why competing with Costco is so hard to do. The firm is not interested in today’s static assessment of performance. It is managing the business as if to raise the probability of long-term success.
After reading that, it’s not hard to see why Amazon.com eventually became another cornerstone of the Nomad portfolio.
Now, we might not all be as lucky as Nick and Zak. Costco was just sitting there at a discounted price in the early days of the Nomad Investment Partnership — allowing them to add a member of their terminal portfolio to their actual portfolio right from the jump. Sadly, it doesn’t always work out that way.
But, as the Boy Scouts say, be prepared. Do the work now so that you won’t miss a chance to add a lifetime holding to your portfolio the next time it drops in price. That may be tomorrow, it may be in six months, or it may be in five years. No one knows.
With the exception of Berkshire Hathaway — which I imagine will be a popular answer around these parts — what are some names on your terminal portfolio?
Constellation Software, which continues to evolve through value-added spin outs and larger acquisitions while maintaining a laser focus on long-term growth.
Wonderful read, thank you for sharing!