Impermanence, Shelf-life, and Scale Economies Shared — Notes from Howard Marks, Nick Sleep, and Others

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Impermanence, shelf-life, and scale economies — Lessons from Howard Marks, Matthew McLennan and more

Master of the Universe?

In Richer, Wiser, Happier, author William Green describes the influence that Japanese Buddhism had on investor Howard Marks. In it, Marks talks about the inevitability of change and the constancy of impermanence. Equilibrium, in his view, implies stasis or death. These ideas ring true not only in life, but in industry and markets too. 

“In the world of business, sameness and stability are not an option. Companies rise and fall, locked in a Darwinian struggle for supremacy and survival, and industry after industry is disrupted by technological innovation.”

William Green. (2021). Richer, Wiser, Happier.

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I don’t know!

Where change is the rule, we have to accept the limitations and blind spots of human knowledge. Or to at least recognize that the systems and dynamics that we shape and are shaped by are inherently complex and unpredictable. “The screwiest thing you can do”, Marks says, “is to think you’re a Master of the Universe”.

Those who’ve studied Marks’ memos know that he does not believe in market timing as a strategy for sustained outperformance — highlighting, on many occasions, the quip by John Kenneth Galbraith: “we have two classes of forecasters — those who don’t know, and those who don’t know they don’t know”. 

“It’s folly to think we know in advance just what it is that will cause the market pendulum to stop swinging in one direction and start in the other, but it’s even greater folly to think that nothing of that nature will happen. That’s my twist on one of my favorite quotes, from behaviorist Amos Tversky: ‘It’s frightening to think that you might not know something, but more frightening to think that, by and large, the world is run by people who have faith that they know exactly what’s going on.’ ”

Howard Marks. (2007). It’s All Good… Really? Memo to Oaktree Clients.

Super cycles and alternative futures

That’s not to say, however, that we cannot say anything about the market system. As Marks explains in Mastering the Market Cycle, most processes in the economic system — from growth and profits to confidence and credit — consist of cycles and oscillations that interact in complex, nonlinear ways.

Sometimes they will lead to a self-correcting, self-regulating equilibrium. On other occasions, behaviors and cycles will amplify one another, culminating in wild, runaway dynamics. George Soros shares a similar view in his theory of reflexivity, describing how feedback loops can lead to bubbles and super bubbles.

Like catching falling knives, knowing where in the cycle a market is at is difficult. For this reason, Marks likes to think not in singular narratives, but in “alternative futures” and “distributions of different possibilities”. This awareness calls for prudence under all conditions. Markets, after all, are most risky when their constituents are most risk insensitive.

While most of us cannot predict the future, prudent investing is not a lost cause. Benjamin Graham’s concept of margin of safety, for example, provides a counterweight against the market vicissitudes. The goal is to buy assets at a sufficient discount to its intrinsic value under a large variety of future states.

At euphoria’s peak, people will argue that no price is too high. And at pessimism’ trough, they’ll believe that no price is cheap enough. Economic reality is probably somewhere in between. The wise investor, Marks reminds, must see past singular extreme narratives to understand what can and cannot be.

Market ecology and entropy

Cycles, oscillations and multiple futures, however, is only one way to look at the market. In his conversation with William Green, First Eagle investor Matthew McLennan believes “that everything [in business] is on a path to fade”. He likens this tendency to biodiversity in natural history. Indeed, the vast majority of species that have ever lived are today extinct.

McLennan’s worldview is analogous to two cornerstone ideas in science: the Darwinian struggle for survival in biology; and the second law of thermodynamics (entropy) — that disorder in a closed system is forever rising (without additional work). Even in the absence of outside threats, companies, like animals, will eventually age and die.

Of course, the scale and dynamics of industry and the economy are different to that of nature. But the ideas from biology and physics are helpful nonetheless. Like Marks, McLennan shows “great respect for the fact that things are not structurally permanent in nature, that things fade”. His goal as an investor then is to “avoid fade”. 

Avoiding fade and disorder

To avoid fade, McLennan looks for “persistent businesses” with strong competitive advantages and high quality management to prolong the organization’s “path to irrelevance”; and “to invest at a 30 percent discount to his estimate of the company’s intrinsic value”.

He also runs “an error-tolerant strategy” of around 140 stocks to account for “mistakes, bad luck, and inability to see the future”. (Curiously, this contrasts with value investors like Mohnish Pabrai who run highly concentrated portfolios — clearly a matter of taste and beliefs.)

Colgate-Palmolive, for example, McLennan argues, is “built for resilience”. The company has sold toothpaste for more than a century and “controls more than 40 percent of the worldwide market”. Combine their scale economies with a strong consumer brand and their resilience to disruption and downturns, and you get yourself a pretty durable operation.

Shelf lives and scale economies shared

Nomad Partnership’s Nick Sleep and Qais Zakaria share a similar view too. Most companies, in their assessment, will age like bad milk. So they want to invest only in businesses with a high likelihood of “a long shelf life”. 

For this reason, Sleep and Zakaria focus on the company’s twenty-year outlook; initiatives and investments to expand its moat; and relationship quality with customers, suppliers, shareholders, and so on (a signal of management’s horizon).  

Sleep notes to Green, however, that there is one standout model in companies with “unusually long shelf lives”. They call it “scale economies shared”. One example, they say, is their 2002 investment in Costco.

At the time of investment, Costco’s share price had fallen from $55 to $30 — Wall Street had signaled its displeasure with Costco’s low margins. Sleep and Zakaria, however, disagreed with the consensus. Low margins, they believe, were a signal of “Costco’s fanatical focus”.

And here’s the crux of it: Costco’s low prices fosters customer trust, which encourages greater spending and word-of-mouth with friends and family. Customer growth leads to increased revenues, which allows for greater scale savings, which allows for even lower costs, better prices, more customers, and higher revenues. Scale economies shared is a powerful cycle.

The special case of Amazon and good judgment

Green points to other companies, like Walmart, Amazon, Dell Computers, GEICO, Tesco, Southwest Airlines, and Nebraska Furniture, that use scale-economies-shared to great effect.

Amazon’s case, in particular, is illuminating. In his 2005 letter to Amazon shareholders, Jeff Bezos told investors that their pricing models could not justify the tradeoff between lower prices and higher volumes. But there are times in business and investing when you need to distinguish between good data and better judgement.

Indeed, Bezos believed that the “relentless returning [of] efficiency improvements and scale economies to customers in the form of lower prices creates a virtuous cycle that leads over the long term… to a much more valuable Amazon.com”. Low prices, in his assessment, were in the best interest of Amazon’s customers and the company by extension.

Such ideas, while “expensive in the short term”, are “important and valuable in the long term”. Indeed, Amazon had to look well beyond the numbers and customer willingness to pay to achieve their dominance. The same line of logic, Bezos notes, culminated in other major initiatives like Amazon Prime and Free Super Saver Shipping.

As Bezos explains:

“Not all of our important decisions can be made in this enviable, math-based way. Sometimes we have little or no historical data to guide us and proactive experimentation is impossible [or] impractical… Though data, analysis, and math play a role, the prime ingredient in these decisions is judgment… Math-based decisions command wide agreement, whereas judgment-based decisions are rightly debated and often controversial… Any institution unwilling to endure controversy must limit itself to decisions of the first type. In our view, doing so would not only limit controversy — it would also significantly limit innovation and long-term value creation.”

Jeff Bezos. (2005). 2005 Letter to Amazon.com Shareholders.

Humility, skepticism, and prudence

There are indeed many ways to think about markets, industry, and competition. Investors like Marks focus on cycles and impermanence, while the likes of McLennan and Zakaria look at ecologies, shelf lives, and paths to fade. The common theme here, Green notes, is in their “humility, skepticism, and prudence”, and “respect [for] uncertainty”. While good investment decision-making is difficult, it isn’t rocket science.

Sources and further reading