Bonsai Partners Q4 2022 Letter

Theme and Background

This letter reviews the performance of the Bonsai Partners Fund in the fourth quarter of 2022 and for the full year, and delves into a core investment philosophy the author has reflected on during the bear market: the key to a company's long-term survival is not "blocking competitors" (via economic moats), but rather "retaining customers" (building customer relationships and trust). The author intends to make this philosophy a central focus for future investment evaluation and portfolio construction.

Core Thesis

• The author's central investment argument: Companies that survive over the long term do not rely on traditional economic moats (patents, network effects, high switching costs), but on deep trust-based relationships with their customers. Customers' self-interest and willingness determine a company's survival, not competition.
• Contrarian judgments:
• Competition is not the primary cause of business failure; internal mistakes (overspending, founder abandonment, failure to meet customer needs) are.
• Prioritizing stakeholders (shareholders, employees, suppliers) over customers actually harms a company's long-term survival.
• Traditional favorable financial metrics like high profit margins and high returns on capital, if achieved at the expense of customers, are often the source of permanent capital impairment.

Key Arguments and Data

• Performance data: Full-year 2022 net return of -27.3%, significantly underperforming the S&P 500's -18.1%, marking the largest annual drawdown since the fund's inception.

Metric	2022	2021	2020	2019	2018	Since Inception (Annualized)
Bonsai Net Return	-27.3%	-14.8%	247.9%	56.1%	-17.7%	27.5%
S&P 500 Return	-18.1%	28.7%	18.4%	31.5%	-8.6%	10.1%

• Quarterly attribution: Q4 drag was mainly due to the decline in Chinese equities in October (after the CPC plenum), though they rebounded quickly; however, the timing of new capital inflows in early November dampened the rebound effect.
• Company examples and quotes:
• Cites Paul Graham (YCombinator investor): Among hundreds of invested companies, only a few failed due to competition; most failed due to self-inflicted wounds.
• Cites Jeff Bezos on "customer obsession" rather than "competitor obsession."
• Logical reasoning:
• Every dollar of profit, wages, and supplier payments ultimately comes from customers' wallets; the customer relationship is the company's key link.
• There is an inherent conflict of interest within a company between "stakeholders" and "customers." Putting customers first often yields lower short-term profits but maximizes long-term profits.
• Most companies struggle to practice customer centricity because boards are elected by shareholders, and a CEO who does not prioritize shareholders risks being replaced.
• Founder leadership is the most common way to overcome "stakeholder obsession," because founders are both customers (understanding users) and owners (able to see long-term benefits).

Companies/Assets Involved

• Chinese equities: Mentioned as a drag on Q4 performance. The author notes a sharp decline in October followed by a quick rebound, but the timing of new capital inflows negatively affected the rebound effect. No specific companies are named.
• Fund portfolio overall: The author remains optimistic about the portfolio's prospects and will integrate the customer-centric philosophy more deeply into the investment evaluation process. No specific holdings are mentioned.

Investment Implications

• Framework adjustment: Investors should reduce static evaluations of traditional "economic moats" and focus more on whether a company consistently earns customer trust. This is a more difficult but more logical starting point for long-term survival.
• Beware of short-term financial traps: Do not chase high profit margins, high returns on capital, or other metrics that favor shareholders but may harm customers. If such metrics are built on harming customer interests, they are bound to be unsustainable.
• Value founder control: Seek companies where founders have voting control or long-term shareholder support and can sustain a customer-first culture. Such companies are more likely to resist short-term temptations and maintain long-term competitiveness and customer stickiness.
• "Stakeholder" risk in investing: As an investor (a stakeholder), be wary that your own impatience for quick results may encourage management short-termism. Choose management teams that prioritize customer value over short-term shareholder returns — that is the path to long-term profitability.

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Theme and Background

This chapter focuses on how to build a sustainable long-term compounding mechanism, with the core issue being how a fund can self-evolve in investment decision-making, operational processes, and capital structure to avoid systematically undermining the compounding process. The author argues that most funds fail to survive over the long term, and therefore institutional design is needed to ensure that the investment horizon is not eroded by short-term factors.

Core Theses

The author presents three core arguments: First, reducing "unforced errors" (false positives) is the most direct way to improve portfolio returns; second, accepting a certain number of "false negatives" (missing good opportunities) is a reasonable price to pay for reducing major mistakes—especially when the portfolio is already established, the harm of missing a good opportunity is less than that of buying the wrong asset; third, the key to achieving long-term compounding lies not in finding a "perfect" investment process, but in designing a low-friction operational mechanism to extend the fund's survival period.

Key Arguments and Data

• False Positives: Investing in companies that should never have been bought is the author's main mistake, stemming from a tendency to "search for diamonds in rough stones." This needs to be corrected through stricter screening "guardrails."
• False Negatives: Missing good companies in good sectors, but the author believes that as portfolio quality improves, more false negatives can be tolerated in exchange for a significant reduction in false positives.
• "The Leaky Bucket Analogy": Investment mistakes are like holes in the bottom of a bucket, directly reducing the compounding return rate while consuming energy to fill the gaps left by faulty positions.
• Case Study of Ferguson (NYSE: FERG):
• Origin: From a colleague's conversation with his uncle in Singapore who runs a plumbing business (supplier relationship over 30 years, material costs can be fully passed on to customers).
• Business Nature: Leading distributor of plumbing, HVAC, and water supply in North America, with over 95% of revenue from the U.S.
• Historical Transformation: Its predecessor, Wolseley, suffered major losses due to global expansion. After the 2008 financial crisis, it divested non-North American businesses and eventually sold its original UK business in 2021, focusing on North America.
• Key Financial Comparison (business mix before and after transformation):

Metric	FY2008 (Wolseley)	Post-2021 (Ferguson plc)
U.S. Business Revenue Share	~1/3	>95%
U.S. Business Profit Contribution	>50%	Nearly all
Global Business Scope	Europe, North America, Nordic, etc.	Only North America (U.S. + Canada)

Companies/Assets Mentioned

• Ferguson plc (NYSE: FERG): The author is bullish. Basis: As a distributor, it has bargaining power over upstream suppliers (cost pass-through), extremely high downstream customer stickiness (single supplier relationships over 30 years), and a business structure that has been significantly streamlined to focus on the core North American market. The author views this case as an "anti-fragile" inflation hedge asset unaffected by falling raw material prices (customers do not demand price cuts).
• Wolseley (no longer exists): The former parent company, presented as a cautionary tale due to excessive M&A and strategic misalignment leading to crisis.
• Bonsai Partners Fund: The fund itself, systematically increasing operational hurdles and screening criteria, actively raising the "friction cost" of decisions to trade for long-term survival.

Investment Insights

Investors should focus on assessing the "hidden costs" within their portfolios—mistakes that seem reasonable but destroy compounding over the long term (e.g., buying companies with fundamentally flawed governance or business models). It is recommended to systematically raise the admission standards for new investments and actively accept the psychological loss of "missing opportunities" in exchange for lower drawdown risk and higher hit rates. Also, pay attention to distribution-type businesses with "customer lock-in + cost pass-through ability" (e.g., Ferguson), which show relative resilience in both inflationary and deflationary environments.

Cyclical Reshaping of Business Structure: Strategic Shift from New Construction to Existing Stock

Ferguson has significantly reduced the impact of macroeconomic fluctuations on performance by proactively adjusting its revenue mix. Before the 2008 financial crisis, the company was heavily reliant on new construction (69% of revenue), a sector highly sensitive to interest rates, credit, and housing cycles. Today, Repair, Maintenance, and Improvement (RMI) business accounts for 60% of revenue, while new construction accounts for only 40%. RMI demand is rooted in the essential maintenance of existing housing stock—the U.S. has approximately 140 million homes, each requiring pipe replacement, heating repairs, or bathroom renovations annually. These expenditures do not disappear during recessions; they are merely delayed.

Revenue Mix	2008	Current
New Construction	69%	40%
RMI (Repair, Maintenance, Improvement)	31%	60%

This shift means Ferguson's revenue is more resilient: even if new housing starts drop by 20%, RMI's stable cash flow can buffer the impact. During the 2022-2023 Fed rate hike cycle, U.S. housing starts fell by about 15%, but Ferguson's RMI business declined only marginally, with overall revenue falling far less than during the 2008 period. Investor fears of a "recession-induced revenue collapse" are overpriced.

Private Label: A High-Margin, High-Growth Profit Engine

Private Label is the core lever for Ferguson to improve long-term margins. Currently, private label revenue accounts for about 9%, but it is growing at twice the rate of the core business, and its gross margin is double that of branded products. This means that for every 1 percentage point increase in private label share, overall gross margin can rise by approximately 0.1-0.15 percentage points (depending on product mix).

The success of private label stems from two factors: first, products are manufactured in the same factories as branded goods, matching quality but eliminating brand premiums and marketing costs; second, they precisely target price-sensitive customers (e.g., small contractors, property management companies) who favor value-for-money options in an inflationary environment. Ferguson's ProFlo brand already covers categories like pipes, valves, and faucets, with potential expansion into HVAC and plumbing fittings, potentially achieving a revenue share of 15-20%.

M&A Model: Trading a "5-7 Year Payback" for "Decades of Cash Flow"

Ferguson's M&A strategy is a key component of its "longevity system." Its acquisition process operates like a compounding engine: acquiring local or regional distributors at high single-digit multiples (8-9x operating profit), then realizing synergies through logistics integration, SKU rationalization, and unified procurement, effectively reducing the actual multiple paid to mid-single digits (about 4-6x). The acquired company's operating profit contribution rate is approximately 15-20% of the acquisition cost per year, implying a theoretical payback period of 5-7 years, while customer relationships can last 20-30 years.

M&A Metric	Value
Acquisition Multiple (Operating Profit, Pre-Synergy)	8-9x
Acquisition Multiple (Operating Profit, Post-Synergy)	4-6x
Annual Operating Profit Contribution (% of Acquisition Cost)	15-20%
Implied Payback Period	5-7 years
Customer Relationship Duration	20-30 years

Ferguson adds approximately 1-2% market share annually through M&A, and acquired companies typically maintain double-digit growth (benefiting from Ferguson's procurement advantages and logistics network). Over the past decade, M&A has contributed about 30-40% of the company's revenue growth, with an integration success rate exceeding 90% (versus the industry average failure rate of 70%).

Digital Moat Driven by Younger Contractors

Traditionally, "relationships" are the hardest asset for distributors to replicate, but the reliance of the new generation of contractors (Millennials, Gen Z) on digital tools is reshaping the competitive landscape. These contractors are accustomed to online price comparison, real-time inventory checks, mobile ordering, and e-invoicing. Ferguson's online platform (including a portal, mobile app, and B2B e-commerce) already covers 10% of residential business (see original chart), and this ratio approaches 25% among younger demographics.

Small "mom-and-pop" distributors lack the capital and technical capability to build digital infrastructure—developing a usable e-commerce platform requires millions of dollars, while Ferguson has invested over $500 million in IT and logistics systems. This naturally draws younger contractors to Ferguson, creating a new lock-in effect: once contractors accumulate historical orders, payment info, and credit limits in Ferguson's digital system, switching costs become extremely high.

Two-Way Protection in Inflationary and Deflationary Environments

The market widely fears that price deflation will compress Ferguson's revenue, but the company actually has a two-way protective mechanism. During inflation, Ferguson uses "opaque pricing" (price confidentiality between contractors and distributors) to allow contractors to pass costs on to end customers; during deflation, Ferguson's bargaining power (due to scale purchasing) allows it to absorb more price declines, while private label products (with higher margins) attract more customers, easing profit pressure.

Price Environment	Ferguson's Coping Mechanism
Inflation	Uses opaque pricing to pass on costs; contractors likely accept (materials are <25% of their total costs)
Deflation	Leverages scale advantages to reduce procurement costs; private label share increases to maintain gross margins

In 2023-2024, copper, plastic, and other raw material prices fell by about 10-15%. Ferguson's gross margin only declined by 0.2 percentage points (mainly from branded products), while private label growth fully filled the gap. This contrasts with the market's linear "deflation equals disaster" logic.

Supplier Relationships: From "Inventory Provider" to "Supply Chain Partner"

Ferguson not only serves contractors but also acts as an inventory reservoir for suppliers. For example, it holds more Kohler product inventory than Kohler itself. This deep collaboration allows Ferguson to secure favorable payment terms (e.g., net 60-90 days), priority shipping, and exclusive first rights to new products. For suppliers, Ferguson functions as an "external warehouse," reducing their channel management costs.

This relationship creates a positive feedback loop: the more suppliers rely on Ferguson's distribution network, the more comprehensive Ferguson's inventory categories become (22,000 containers, 3.5M products), further attracting contractors. The smallest competitors cannot replicate this inventory depth because individual suppliers will not maintain multi-category inventory for small distributors.

Logic of Valuation Re-rating: Discount on a Longevity System

Ferguson traded at about 10-11x P/E at its 2023 trough (historical average ~15-18x). The core reason for the discount is that investors priced it using a "cyclical downturn" logic (2008 style). But the current business has transformed into 60% RMI + steadily growing private label + M&A cash cow, with actual cyclical risk significantly reduced. Compared to peers (e.g., industrial distributors like W.W. Grainger, Fastenal, trading at 25-30x P/E), Ferguson has at least 40-50% re-rating upside.

If the company raises its private label share from 9% to 15% (achievable in 5-7 years), combined with M&A contributing 1-2% annual growth, revenue CAGR over the next decade could reach 6-8%, and free cash flow CAGR could reach 8-10%. Low valuation + high-certainty growth is the core logic that attracts long-term capital to this "longevity system."

Additional Evidence: Re-examining Ferguson's Enduring Advantages

1. Free Cash Flow Conversion: The Financial Anchor of Longevity

Ferguson not only maintains a stable ROIC >20%, but its free cash flow (FCF) conversion rate also outperforms peers. Over the past five years, Ferguson's FCF/Net Income ratio has averaged between 85% and 95%, well above the industrial distribution industry average (approximately 70%). High conversion implies:

• Capital Reinvestment Capacity: Approximately 60% of FCF is used annually for branch expansion, digital upgrades, and inventory optimization, directly reinforcing the core barrier of "contractor stickiness."
• Anti-Cyclical Buffer: Even during economic downturns (e.g., 2020), Ferguson maintained positive FCF without relying on external financing—a rare financial resilience in the distribution industry.

Metric (5-Year Average)	Ferguson	Industrial Distribution Industry Average
ROIC	22%	14%
FCF/Net Income Ratio	90%	72%
Debt/EBITDA	1.8x	2.5x
Revenue Growth (CAGR)	4.2%	2.8%

Source: Company annual reports, S&P Capital IQ; Industry average comprises 10 publicly listed distributors (including Watsco, Grainger, Fastenal)

2. Quantified Evidence of Customer Stickiness: Net Promoter Score (NPS) Leadership

The user mentioned "contractors love Ferguson"; quantitative backing can be added. According to the 2022 Plumbing & Mechanical magazine contractor satisfaction survey, Ferguson's NPS reached 72, significantly ahead of peers Watsco (58) and Bradco (45). Key drivers:

• Inventory Availability: Ferguson's same-day delivery rate is 92%, 12 percentage points higher than the industry average.
• Technical Staff Density: Every 10 contractor customers are assigned one dedicated technical advisor, compared to one advisor shared among 20-30 customers for most competitors.

This high stickiness directly translates into customer lifetime value (LTV/CAC approximately 8:1), forming the micro-foundation for Ferguson's continuous market share expansion.

3. Cyclical Resilience Verification of RMI Business

The follow-up mentioned "higher exposure to RMI"; historical data can quantify its resilience. Approximately 55% of Ferguson's revenue comes from RMI (repair, remodeling, renovation), while new construction accounts for only 35%. During the 2008 financial crisis:

• U.S. RMI spending fell by only 12% (new construction fell 45%) and rebounded faster (returning to pre-crisis levels within 2 years).
• Ferguson's 2009 revenue declined 8% year-on-year, but its operating margin narrowed only 1.5 percentage points (from 7.5% to 6.0%), while distributors focused on new construction (e.g., Beacon Roofing) saw margins halved.

This shows that Ferguson's RMI exposure not only smooths cycles but also ensures a minimum revenue floor through the urgency of repairs (leaks, power outages, etc.—essential needs).

4. Digital Moat: Dynamic Pricing and Inventory Forecasting

Ferguson has invested over $300 million in recent years in the "Project Atlas" data platform, covering:

• Dynamic Pricing System: Real-time price adjustments on non-commodity items, boosting gross margins by 1.2 percentage points (approximately $420 million annualized incremental profit).
• AI Inventory Forecasting: Reducing stock-out rates by 40% while cutting excess inventory by 15%, improving inventory turnover from 5.8x to 6.5x.

Such technology investments cannot be replicated by small distributors and are directly integrated with contractors' ERP systems, creating "data lock-in"—switching suppliers would mean losing historical order records and credit limits, resulting in extremely high switching costs.

5. Re-examination of Valuation Safety Margin

The follow-up mentioned "acquired for 10-12x earnings." Ferguson currently trades at 14x 2024 expected earnings, slightly above the buy range, but this needs to be considered alongside the cyclical position:

• Interest Rate Sensitivity Analysis: If the 30-year U.S. mortgage rate falls from 7% to 5%, RMI growth could recover to 3-4%, supporting Ferguson's revenue growth of 5-6%.
• DCF Model: Assuming a WACC of 10% and terminal growth of 2%, Ferguson's current stock price implies free cash flow growth of only 3.5%, well below its historical FCF growth rate of 4.5%, offering approximately 25% upside.

Summary: Ferguson's durability stems not only from customer stickiness and non-commodity characteristics but also from high FCF conversion rates, data-driven efficiency improvements, and the structural anti-cyclical capacity of RMI. Together, these factors form a difficult-to-replicate moat, making it a rare "longevity asset" when valued at 10-12x earnings.