[00:00] Rob Campbell: The topic this week on the Art of Boring: Sell discipline. What it is, what can get in the way of sound decision making, and how it's enabled by various aspects of our process. Plus, what sell discipline at Mawer looks like in practice. Portfolio Manager Jeff Mo joins me, that's Rob, and to borrow from Charlie Munger, he inversion may actually offer some insights into what good buy discipline looks like, too.

[00:00:27] Disclaimer: This podcast is for informational purposes only. Information relating to investment approaches or individual investments should not be construed as advice or endorsement. Any views expressed in this podcast are based upon the information available at the time and are subject to change.

[00:00:43] Rob Campbell: Jeff Mo, welcome.

[00:00:45] Jeff Mo: Thank you, Rob. Good to be back.

[00:00:47] Rob Campbell: Yes. Well, I'm glad you're back. Actually, before I get to you, I wanted to give a shout-out to one of our listeners and thank them for this week's topic. Basically, a client who said, “We listen to your podcast all the time. We have a really clear understanding of what you look for when you buy companies, but we'd just love if you could devote a full episode to your sell discipline.”

And it was a great suggestion. Hence, Jeff, that's why you're here. And I'm thinking, Jeff, maybe this episode could be over really quickly in the sense that we buy wealth-creating companies led by excellent management teams and purchase them at a discount to intrinsic value. Is the sell discipline that simple in the sense that it's just the very opposite of those three things?

[00:01:27] Jeff Mo: I would say yes, it is. In that, in the order that's most important for us as a buy discipline, the sell discipline tends to carry with it a little bit more psychological baggage as well. Especially if you aren’t in the green on that particular investment. On a nutshell, yes.

[00:01:45] Rob Campbell: Let's dig into some of those behavioral aspects that influence it's different when you don't own a stock. I mean, it shouldn't be, but it's different when you don't own a stock versus when you've owned it, and you've got a track record with it. Can you dig into some of those more common behavioral pitfalls that can get in the way of clear decision making with respect to sell discipline?

[00:02:03] Jeff Mo: So what you just described is what Kahneman and Tversky call endowment bias. When you own something – my wife actually has great endowment bias. She even told me that she was very unsure about me the entire time we were dating. But once she said yes to my ring, she was all in. She's like, “Yup, you are the man for me.” That's endowment bias. And of course, I hope my wife's not listening to this podcast.

I don't want her to take the advice I'm about to give our listeners is: Try to always be considering your holdings. Don't get married to them. I joke because this is, of course, not a marriage advice podcast. I hope you guys are not taking this as such, but the cure for endowment bias is to always tell yourself that you don't need to own this.

It's not a full cure. The psychology about biases, if you study behavioral psychology, even briefly, you'll know that there is no ever cure. We are hardwired in our brains to have some of these biases. And there is an evolutionary benefit in many cases to have an endowment bias. But I think the first step to trying to balance them out is to recognize that it's omnipresent.

That's why we have tools. I think the matrix is one of the best tools to try to balance that endowment bias because if you have an inventory idea that has a better-quality ranking and a better return potential ranking, you have to really start defending why you still own company XYZ that maybe is on the discussion for potential seller exit.

[00:03:38] Rob Campbell: I think you mentioned earlier this idea that you might have losses or you might have gains associated with a holding when you're thinking about whether it's the right time to trim or exit. How does that kind of play into things and potentially complicate?

[00:03:50] Jeff Mo: In addition to having tools, I think it's having your process in mind at all times is very important. So when we buy, we very clearly try to go through and explain to ourselves and judge why the company is wealth-creating, why it has a sustainable competitive advantage, why we think the management team is excellent, and, on a probabilistic basis, why is it trading at a discount to intrinsic value?

To go back to what you said, our sell discipline should not be more than the inverse of that. But oftentimes, we can get in our own heads, and it can become more than the inverse of that. That's why with the tool to tell us – the matrix – “Oh yeah, actually, these companies over here might not be such a good opportunity anymore.”

Let's just walk it through the sell discipline. Is it potentially no longer trading at a discount to intrinsic value? The probability of it is very low. Has the management team slipped through either we've learned more about how they think, or they have proven to the actions that perhaps there is not alignment in word and deed, or perhaps their ability to execute is not as strong as we thought.

And finally, and most importantly for us, is the competitive advantage is still sustainable and strong? That is how we look at it – is that, as you go through those three, the faster you would want to sell. If the wealth creation, the most important part of our buy thesis, is impaired. And that's what we try to do every day is just to take the emotion out of it, which is very, very difficult, and just go through logically and say, “Is this company still meeting that criteria?”

[00:05:27] Rob Campbell: Another thing that Manar had talked about on this podcast, not too long ago, was this idea I think he'd read in a paper. Somebody did a study and felt that institutional investors were often sort of better at buy decisions than sell decisions. One of the reasons this particular paper had posited was, “Well, maybe you just spend more time in your buy decisions, whereas your sell decisions happen quickly.” Is that your experience? Do we have tools, in addition to the matrix, that help us slow down with that respect as well?

[00:05:55] Jeff Mo: I'm not sure what to call this in psychology, but maybe the shiny new toy syndrome. That's probably not a psychological term. But I think the prospect of buying something is exciting – something new, something that will help deliver a better risk-adjusted return for our clients than the current portfolio average. You want to put your brain power there. What's a lot less exciting is a company that's been a drag for two, three, five years, compared to the portfolio average; a company that perhaps you have lost money on behalf of your clients for. It's harder to put mental energy into analyzing that with the same degree of energy.

So I think that's something you fight as well. That's why we have regular matrix meetings. That's why we do a Delta report on every company in the portfolio, not only the ones that are going up faster than the market or only the ones that are going up. I think these are mechanics in the process that force us to think deeply about companies that we may not immediately gravitate toward.

[00:07:07] Rob Campbell: Jeff, the situations you described with respect to the inverse of the buy decision - with respect to triggers, sometimes it can be the fundamental analysis that drives the sell decision. And I'm sure we'll talk about some examples in a bit, but sometimes it can be, presumably, just the price itself.

I know some investors have stop-loss procedures where if the stock drops by a certain amount, they won't ask questions; they'll eliminate it on the spot or have a policy around that. Now we don't, or at least I don't think we do formally.

[00:07:38] Jeff Mo: We don’t.

[00:07:39] Rob Campbell: Why is that? Can you make the case on both sides? What's the benefit of having that policy, and why have we chosen not to?

[00:07:45] Jeff Mo: It's just because valuation is not the most important plank of our sell discipline. It's whether the wealth creation is impaired or whether we believe the management team is no longer excellent. In fact, with a stop loss specifically, if a stock price has dropped, everything else qualitatively about the company is the same, as well as the macroeconomic environment it operates in, then actually that company should be more attractive, objectively speaking.

Of course, we never have full, complete information. You're always operating somewhat in a vacuum or in a fog of war. A stop loss would be very anathema to our investment philosophy because we are trying to judge whether a company has had its competitive advantage impaired, or maybe the management team is not as strong as we thought. Those things require qualitative analysis.

If a stock drops 21% and your stop loss was 20% and the machine automatically executed the trade to sell you out before you've even had a chance to analyze the situation – maybe it's a situation where they've reported a very weak quarter and the trailing 12-month return on invested capital is now no longer greater than the weighted average cost of capital – you don't just sell out because of that blindly. You would analyze and say, “Could this have been a one-time issue? Could this have been something that is temporary?” Or, “No, something permanently has shifted, either in the company's ability to sustain its competitive advantage or potentially something has shown us that our initial analysis of the competitive advantage was not as robust as we thought.”

[00:09:21] Rob Campbell: Can you make this a little more tangible for us? In your time at Mawer, I'm just wondering if you've noticed any sort of patterns of behavior with respect to your own decisions or times when we've missed with respect to sell discipline. What's gone into that? Can you give us an example of how that's worked out?

[00:09:38] Jeff Mo: It's funny – you would think that the sell misses are the worst of the ones that have gone down a lot, and maybe you mentally avoid them, and so you don't make a decision, and it goes down some more. To be fair, in my career and in my observation of my colleagues here at Mawer, there is some of that. But I think the worst ones are actually the ones that go nowhere; that's a little bit counterintuitive, but going back 100 years, the equity markets have tended to compound around 9% per annum on a nominal basis per year.

We've had companies that we've owned both in the Canadian small-cap strategy as well as the U.S. mid-cap strategy – the two I'm involved in – where our companies have been flat or slightly down and basically flat for three, four, or five years. The worst part often is the return on equity or the return on invested capital is still in wealth-creating territory, but the company is poorly allocating that excess capital or the dynamics of the environment in which the company operates has shifted or maybe growth is slowing. So whatever wealth is created is eroded by the fact that the market thinks the continuing value of that company is no longer as high because the growth has come down.

I can think of Canadian small-cap Winpak would be a great example, a company that did really, really well for over a decade and had a pretty innovative management team in innovating plastic packaging for food and beverage. And then plastics obviously became a little bit more out of favor. For whatever reason, their innovation took on a little bit less with the market. They also had an issue with their largest customer that started diversifying away from Winpak a little bit. So a bunch of little things, but that's a stock that's largely been flat for five, six, seven years. Arguably could still be a mistake we're making today because we still own it in.

In the U.S. mid-cap strategy, we had a company called SS&C Technologies. They are a pretty large player in providing software and outsourcing services to companies like ourselves – asset managers, wealth managers, hedge funds, private equity funds, and so forth. We thought it was a well-run company with good market position, and I think all those things are true. They started to make some acquisitions that were a little bit outside their core. It's still a little bit unclear whether or not those acquisitions have or will work out, but I think the market has taken a dimmer view to that new strategy. In the interim, they've really struggled to find any source of organic growth in their markets, probably because active asset management is an industry that has suffered a little bit as passive continues to increase.

Those would be two examples where we largely just held on for quite a while, believing our thesis was mostly correct but maybe a little too optimistic. Those are very interesting mistakes that we've made.

[00:12:38] Rob Campbell: I think they're interesting for a couple reasons. One, which you highlighted, just this notion that it wasn't so much the impairment of capital that came with this, just the lack of participation in the market over a period of years. The other one that seems common between the both of them is just that there wasn't some clear, material thing that changed all at once. It was a combination of small things. I would imagine that if some company made a huge acquisition so far outside of their circle of competence, that might be pretty easy to say, “Hey, this has shifted radically on the matrix. We ought to do something.”

How do you calibrate some of those little pieces of evidence that, by themselves, they're maybe not too much, but they start to add up? At what point do you determine that significance?

[00:13:19] Jeff Mo: That's something we are asking ourselves. We have credit to Samir on this one; Samir is my co manager on the Canadian small-cap strategy. In fact, he is now the lead manager on that strategy. He's instituted this concept of “look back.” We've done this off and on, but he's really trying to make it a little bit more systematic for our team. Winpak, one of the companies we just talked about, was actually on that look back. I think our learning was just being complacent in the story or the deductive evidence that management was telling us, which had not changed for all this time because we meet with management every year, at least during the delta process, maybe sometimes more.

We have notes saying every year, they said, “Oh, yes, we still think we are a high single-digit grower. We still think we're a very innovative market. We still think the market wants that innovation. Here are five or six new products that we are planning to launch.” It always sounds really good and really exciting at the turn. It's just around the corner and then it doesn't turn. I think weighing the inductive evidence a little bit more than the deductive evidence, which is very difficult when it's a company that has done really well. Winpak was in the portfolio before I joined Mawer, even as a summer student, which was in 2006.

So this is a company we've held for literally two decades. It's very difficult to change your mind on that.

[00:14:40] Rob Campbell: There's that endowment bias.

[00:14:42] Jeff Mo: That huge endowment bias, correct. But I think one learning is: Don't overweigh the deductive, look at the inductive. We have lots of tools for that, as well. We have something called earnings monitor, where we married together the standard financial metrics that you could find in any financial service provider with key performance indicators that we've custom chosen that are impactful, in our opinion, for that particular company. When you marry those metrics together and you look at them over a time series, you start to get a better sense of inductively what is happening.

So it's not just what's the revenue growth and gross profit growth of Winpak. But how about the volumes? The volumes of different segments? How does that compare as the resin Price Index moves up and down? When you look at a wider set of data, you start to realize maybe things aren't going as well. I actually think some of those indicators are pointing to a slightly better setup for the company. CapEx is rising again. And it's one thing to talk about innovation. Another thing to actually build factories for that innovation, so we won’t have it there.

I would say MTY Food Group in Canadian small-cap would be a great example of a company where we've made at least 10x for our clients from the very first day from the very first share that we bought. It was very, very difficult for us to change our minds on that. So that endowment bias becomes higher. I think you could look at 2017 or so. The stock went flat for six or seven years, largely because they started making larger acquisitions; the return on invested capital of those acquisitions was lower. And the company has always had more of a strategy to buy cheaper assets in the market. Why are they cheaper? Because they tend to not be as strong brands. They tend not to have strong competitive advantages in and of themselves, and therefore they have lower growth. So now they've grown to a size where if you're paying a little bit more for those acquisitions and you have low growth, it's very difficult to create wealth with those acquisitions.

It took us several years to finally recognize that. Actually, the capital allocation might be a little bit different at MTY, not night and day change, but just a little bit different enough that the math no longer works in today's higher interest rate environment. So that is a company that we chose to exit recently.

[00:16:53] Rob Campbell: It actually begs another question that I had. We're long-term investors. You've talked about a number of companies here that we've owned for many, many, many years. Does that get in the way in the sense that, “Hey, we're a long-term investor. We should hold on to things for long periods of time”? But if something changes within a year or two, do you ever find that that gets in the way of making the right decision?

[00:17:13] Jeff Mo: Yes, absolutely. So Winmark is a really great example. This is a company that we've held since the inception of the U.S. mid-cap strategy, but we recently exited. For us, that's a relatively short holding period. But all the way through that exit – and it wasn't just a one-and-done; we must have made seven or eight trims all the way through – I kept telling myself, “This is fundamentally a good company. We are long-term investors. I'm increasing capital gains for investors,” and all of these thoughts that go through your mind. But fundamentally, when I looked time again at the discounted cash flow model and then quarter after quarter in our earnings monitor, as each new set of earnings came out, it just wasn't lining up. The probability that this company is trading at a discount to intrinsic value has dropped lower and lower. Winmark is a great company, probably one of the highest margin companies in not only the strategy but at all of Mawer.

[00:18:06] Rob Campbell: Just for listeners, this is the used clothing and other used goods franchise.

[00:18:11] Jeff Mo: Yeah, franchisor of used products, clothing being the most common product that people buy used. They have steady growth. They tend to do better in recessions because people tend to trade from buying new to buying used. It has a lot of great characteristics. Plus the penetration of used clothing is still going higher and is a bit on theme. I think there's a bit of a push back against consumerism nowadays. Some of the younger generation, especially, want to buy used and to thrift. It's hard to sell a company that's on trend, that is defensive growth, but I think on multiple, it got to 40 times earnings at one point.

Through a period post-pandemic, the company had also become more focused. They had discontinued a second division that they had, which was a leasing business and had nothing to do with the core business. They had focused all the energy on the core business. They were starting to sign up more franchisees through this focus. Things are starting to come through, and you're starting to see it in the numbers. The growth, at one point, got into the low teens when you consider just the franchising division. So we said, “Okay, we can see why that would justify perhaps a higher multiple.” But then the growth rate started pulling back largely because retail, as well as just generally, the COVID boom has come off a bit. And yet the valuation was still quite high, so I think this was when we eventually exited our position.

But as I was saying earlier, the Jeff of five years ago may have found that difficult because of our investment philosophy. That's just the learning and maturation of investors and the psychology ultimately that comes into play with investing. This is a team game, but this is also an individual game, right? I’ll use a hockey analogy for our Canadian listeners. You have to individually shoot the puck or make your hit, do your back check while still playing in the system, and get off the ice when you're tired, all the things that make hockey a team game.

[00:20:19] Rob Campbell: Do you find that as a long-term investor, we tend to sell slowly? By that, I mean you mentioned several different tickets trimming on the way down versus selling quickly all at once.

[00:20:29] Jeff Mo: I would say for valuation reasons, that's probably fair. Not necessarily because we're long-term investors, but just because that's the weakest point of our sell discipline. Because if you look at our discounted cash flow models, often the fair value ranges can be quite wide because we are open to the fact that the world can and often does unfold in very different scenarios.

[00:20:50] Rob Campbell: Especially if you’re a great management team.

[00:20:52] Jeff Mo: Exactly. Winmark, at one point, we thought it was only a 5% chance, so still undervalued, but there's still a chance it was undervalued based on our discounted cash flow. But if you look at companies like Premier, Cellebrite, or Take-Two, these would be ones where our view on the business model and management or the risks had changed materially, and we got out relatively quickly.

[00:21:14] Rob Campbell: Jeff, where have we done a good job with sell discipline? Where has it really just gone exactly the way that it should?

[00:21:20] Jeff Mo: Usually a good job means not losing more money as opposed to anything else in sell discipline. One that I can think of off the top of my head is Premier, which is a holding in our U.S. mid-cap strategy and global small-cap Strategy. And both got out. Premier is one of three companies in the healthcare group purchasing organization. It’s a group purchasing organization. So essentially they help a bunch of hospitals and clinics and other care organizations combine their purchasing power, which in the U.S. – a more fragmented healthcare system – is a big deal. The theory was that they help the clients essentially bundle their purchases and then negotiate a better price with the providers of various healthcare consumables and devices.

The thought we had on our mind was with only three players in this industry, they should probably have pretty resilient pricing power and should be pretty inflation resistant. When we invested, the valuation looked pretty good, assuming that even though we knew we were going into a slightly higher inflationary period, presuming that they could pass on inflation. After one or two years of being investors in this company, it became apparent to us that they were not passing on inflation as much as we had thought and that really made us question that competitive advantage.

Maybe it's actually either the hospitals and their clients have more negotiating power against them than we thought, or perhaps their suppliers have more negotiating power against them than we thought. But either way, the competitive advantage we thought they had by being one of the big three didn't really matter. It wasn't really there. And we exited already at a loss. I think since then the company, unfortunately, has done a little bit worse.

Another good one would be when management or assessment management, something changes. So there was a company in our U.S. mid-cap strategy as well called Take-Two Interactive. They are a video game maker, probably best known for Grand Theft Auto. We like franchises like Grand Theft Auto – and they also own NBA 2K, the basketball video game – because these are very strong franchises that attract a lot of players, and every time they release a new version, you get a lot of new purchases. It's a relatively steady eddy business.

Video game, in general, is still a growing industry, so you get some growth as well. However, they made a very large acquisition that almost doubled the size of the company when they purchased Zynga, a mobile video game developer. Mobile games tend to be hyper-casual. They tend to have very different monetization methodologies, but generally, they just don't have that ardent fan base that will come back for more. Grand Theft Auto has been around for 15 years and more. Some of these games have two or three years of strength and then they start fading. It was very different. It really changed and weakened, in our opinion, the competitive advantage of the company on an overall basis.

More importantly, they paid a very high price going into a period where Apple had just changed some of their privacy rules around tracking a user within the iPhone as they moved from app to app. And that would make it very difficult for a mobile game company to market. This was sort of known; this was talked about; everyone was saying that Zynga and others will have the cost of customer acquisition go up, i.e., their profits have to go down going forward. Yet, they paid a very full multiple, full price for it anyway.

We took a little bit of time to assess it and make sure that our thesis was correct. We didn't exit the second day after the announcement. Maybe we should have in hindsight of how the stock played out. What ended up happening was the stock price – and the market was so upset – the stock price dropped to the point where the Zynga asset was no longer worth anything according to the market. And the base business is now worth 20-30% because the stock had dropped a full 50% on basically this acquisition from what we can surmise.

So we said, “Okay, the valuation is too cheap at this point.” We re-evaluated management on the matrix to a much lower score. When the valuation recovered about halfway, which is roughly the value we thought management had destroyed through this acquisition, we exited what we thought was a fair value, but now it was a much lower matrix score quality. That's another example where we were quite comfortable with that decision, even though I think since then, it's kind of been a bit of a wash from a stock price perspective.

[00:25:30] Rob Campbell: Jeff, you've spent your career in the small- and mid-cap space. Whether it's different parts of the market cap spectrum, or maybe different geographies or different industries, does the sell discipline adjust based on those factors at the margin?

[00:25:47] Jeff Mo: It shouldn't. If it does, it's because of psychological biases, not because of any plan. The sell discipline shouldn’t adjust.The sales should adjust based on where we think the competitive advantage is trending, where our judgment on management is and is trending, and what probability of discount we think the current share price represents.

[00:26:07] Rob Campbell: I'm thinking maybe in the small-cap space. You might just own more of that business. You might own 10-12% of the actual company. It might take you a lot longer to get out of something. Are you more sensitive to negative news and to move quickly knowing that it might take you some time to exit the position completely?

[00:26:26] Jeff Mo: That's actually where the buy discipline comes in. If you buy wealth-creating companies, even if it's like Winpak and MTY where maybe the wealth creation starts eroding a little bit. It's not like the company's suddenly not worth anything. You're racing to the exit with everyone else who's also realized it.

[00:26:41] Rob Campbell: I feel like we're getting closer to the marriage analogy again here.

[00:26:46] Jeff Mo: It’s still a well-rounded asset. We probably managed to sell that, probably over two, three, four years of trims and not in the market all the time, but just over time, we got a little bit less confident in the thesis and started to reduce our position. I would not say that because we sometimes, in smaller cap companies, own more of the shares, it makes us more flighty or more jumpy. If that's what perhaps you're implying with how you worded that question.

[00:27:15] Rob Campbell: I think your answer just connects so well back to the buy discipline that's important in the first place. To reduce the chance of flightiness in the end.

[00:27:22] Jeff Mo: I think it was Buffett who said that our, in this case, Berkshire Hathaway's preferred holding period is forever. And the word to key in on is preferred. Not everything in life goes the way you prefer it to go. So the sell discipline really is talking about situations when you're out of your preference.

[00:27:42] Rob Campbell: Are there any other aspects of the way that we go about investing that you think are important that we haven't talked about so far when it comes to sell discipline?

[00:27:50] Jeff Mo: The concept of behavioral psychology is very important. I would say it's not quite in our process in the same way that we have a discounted cash flow model or so on. As I talked to more and more of my fellow portfolio managers here at Mawer, I realized we all have some form of a checklist. If you read the book The Checklist Manifesto (by Atul Gawande), checklists are one, a great way for you to be systematic with your thinking process, but two, a great way for you to slow down.

Sometimes you are thinking of selling a company because there's been a huge move in the stock price. Some news came out that's making you question your thesis. Emotions can come into play. We know when emotions are high-order, thinking in the brain gets suppressed, and we become more like cavemen. We get amygdala hijacked, a term I learned. So something like a checklist is really helpful for you to go through and think through. Does this make sense? Is this company, according to your current analysis as well as your teammates, is it actually that much worse than the market average? The portfolio average?

That's where your matrix comes in. You can reread the Delta report. You can reopen the model and play around with assumptions and inputs. Is it truly trading at almost no discount to intrinsic value? Remind yourself of these psychological biases. In this case, it could be some type of fear response that's causing you to want to exit very quickly; it could be another reason or vice versa. You don't want to exit because it's going to make you look bad or all of these psychological things. So a checklist is one tool.

Another tool that I'd say is only kind of starting to be used more systematically at Mawer is this concept of trigger points, things that you look for along the way. Specifically, if you can come up with them prior to those things actually happening. Sometimes it could be a price target, but often it's a qualitative factor. Such as: the next big contract that's currently in the RFP; if this company doesn't win it, that would be quite surprising given how strong we think the competitive advantage is. That would be a time to check in on that competitive advantage. If you notice that margins are decreasing rather than increasing or have decreased past a certain level, that's surprising given the competitive advantage or given the management comments on the execution trajectory that they were expecting.

There could be a lot of those things. Often an acquisition that looks completely different than what you were expecting management to do could be a very common signpost to check in on. Those are things that are another way to force that discussion in your mind of, “Okay, are you sure you want to be holding this because that was something you said six months ago that if it happened, you are likely not very confident in your thesis.”

[00:31:02] Rob Campbell: Write it down; journal it so you can’t go back and do some revisionist history.

Well, Jeff, thanks for joining us. Thanks for slowing us down to talk about sell discipline. Thanks so much to our client for the suggestion. For all the rest of you, if you have suggestions for things that you'd like us to cover on future episodes, definitely let us know. You can email us at podcast@mawer.com. Jeff, thanks again.

[00:31:26] Jeff Mo: Likewise, you as well. Thanks for having me.

[00:31:29] Rob Campbell: Hi, everyone. Rob here again. To subscribe to the Art of Boring podcast, go to mawer.com. That's M A W E R dot com forward slash podcast or wherever you download your podcasts. If you enjoyed this episode, please leave a review on iTunes, which will help more people discover the “Be Boring, Make Money” philosophy. Thanks for listening.