Is the departure of a CEO a sell signal?

Q. A few companies you invest in have announced changes to CEOs in recent times including Disney, Boeing, and Starbucks. Does this change your view of a company, and what is your process when a key person leaves in one of the companies you own or are considering buying?

Aziz Hamzaogullari: Roughly half of our portfolio businesses are founder-driven businesses - founders are still involved and managing the companies. The other half have professional management, like in the case of Boeing, Starbucks, or Disney. In those cases, in the last 18 years, we have had situations where management has changed and in each situation what we ask ourselves is: “Fundamentally and structurally, is this still a good business or not, and has anything changed with the change in personnel?” Specifically, in a company like Boeing, it's a duopoly between Airbus and Boeing. So, the change in CEO didn't change that structure. Disney is a great franchise with a library of movies and other important assets that would be very, very difficult to replicate by someone else. And Starbucks is a great brand.

So, in each one of these cases, actually, we thought the changes were necessary. But the fundamental question we ask ourselves is: “Is that business still structurally sound and good and do we still find this business attractive or not?”

Q. Holding onto losing stocks for too long can have a large impact on performance. How do you know when to sell a stock, and how do you ensure you're sticking to this discipline?

AH: At the very outset of each investment we identity all the key drivers for our investment thesis for a particular business. Each quarter, when these companies report their numbers, we look at what we thought would happen versus what actually is happening, the predicted value versus the actual observation. The key is understanding your key assumptions and if there's a structural change or not in those key assumptions.

In 18-plus years, we’ve sold around 57 companies from our portfolio. Out of those, roughly half of them we sold because they reached our estimate of intrinsic value. Meaning, everything worked out from our initial investment thesis. Around 25% to 28% of them, we sold because we found a better investment opportunity. And 16 companies, out of those 57 companies, were actually mistakes. So, in 18 years, we made 16 mistakes.  We have a list of these companies and we also know what happened after we sold them.

I’m happy to report that of those companies we identified as mistakes - and sold - 87% meaningfully underperformed our portfolio. That's also the case for those companies we said had reached intrinsic value - 88% of them underperformed our portfolio. The point is that not only did we identify these mistakes, but we acted on them. And importantly, we then kept track to understand whether or not our thesis of our mistakes were correct or not in each case. Meaning, you don't want to make the mistake of selling a company, thinking that it's a mistake, that then ends up outperforming your portfolio.

It’s no different from sports team who, when they lose a game or a win a game, watch the tape to understand where they made good decisions and where they made mistakes. Our investment team does the same.  We have a list of these companies, we understand what our mistake was, and what to learned from each.

Q. Can you tell us some of the things you learned from selling out of those names?

AH: The biggest thing we have learned is the importance of having a clear process around recognising a mistake. That happens only when you have a collaborative investment approach like we do as a team. At the point where an analyst introduces their investment thesis, the entire team sits down and talks about all the key assumptions and as time passes and as we realise the difference between what we assumed was going to happen and what is happening, that's when we trigger the process of saying: "Maybe this is a mistake. We thought the company was going to gain market share, and they're losing market share. We thought they're going to expand their margins, and that's not happening."

A great example is way back in 2008, when we sold Citigroup. We made that decision because we realised that the downside risk was much bigger than we thought. We all got together as a team and agreed that we had underestimated the structural downside in this business and we got out of it in September of '08. Since then, that business has underperformed our portfolio by 750% on a relative basis. But not only that, we took the proceeds and invested in businesses like Visa, which has truly outperformed not only Citigroup but also our overall portfolio.

Listen to the full podcast this Q&A was based on where Aziz discusses the future prospects of the mega-cap tech stocks as well as his team’s Alpha Thesis - the deeply held beliefs and disciplined process which guide what they do every day.