Avoiding the ‘Uh-Oh’ Moments

"The cost of this kind of myopic learning system is that it will sometimes ignore the obvious." - Marc Hauser, evolutionary psychologist at Harvard

Marc Hauser gained notoriety in the ‘90s for his psychological studies and experiments on animals to try to uncover patterns in thinking and connections to human behavior. In one study, Hauser trained a rat to navigate a maze to reach food. He gave the rat a script for where the food would be. When he changed the location of the food, moving it to the beginning of the maze, the rat ran right past it to get to where its script told it the food previously was. The script that the rat was given caused it to ignore or discount new information, even when it would have been helpful. 

Human beings and investors have some of the same scripts. They can be beneficial, as we use them to override manual thinking to preserve energy, and ‘turn our brain off’ with mundane tasks. An easy example might be if you’ve driven the same road 100 times, you may ignore a new route that’s built, even if it becomes obviously faster. Unfortunately, the efficiency of our scripts comes at the expense of paying attention to real information coming from our environment. For investors, this can be harmful. 

Our models and scripts form the basis of how we act and what we believe. We tend to not notice things that are inconsistent with the scripts we’ve been given (or told ourselves) and tend not to notice what is bad about those scripts. I posit that we should never ignore the obvious, even if it means having to override our impulses. 

At one point during my NBA days, I was evaluating the next move in my career which involved interviewing with a few different teams and then weighing any offers before accepting one of the positions. I thought I was headed to Charlotte to work for the Hornets until Michael Jordan (the owner at the time) implemented a hiring freeze on the entire organization. Thanks MJ. 

As a result, my final decision was between the Rockets and the Bucks. The Bucks flew me to Milwaukee for the day, I met with the entire staff, they took me out to lunch and drove me back to the airport. In a coincidence that will likely never happen again in my lifetime, a disgruntled FAA employee, in a bizarre suicide attempt, set fire to one of the air traffic control towers, causing all flights for the day to be cancelled. The Bucks sent a staff member back to the airport to pick me up, he took me out to dinner, they rescheduled my flight, paid for a hotel for the night, and treated me to a complimentary breakfast the next morning. They even drove me to CVS so I could grab some contact solution. I remember thinking on the flight home, I’m moving to Milwaukee. 

When interviewing for the Houston job, they only went as far as talking to me over the phone. I spoke with two executives on the basketball operations team, and they offered me the job. The interviews were ok, and the people seemed ok, but I remember thinking how strange it was that they didn’t want to meet me in person. However, the Rockets were much more competitive than the Bucks at the time, the compensation was a bit better, and I remember having some reservations about living in Milwaukee. I chose Houston, with the rationale being that if I can say I worked for these guys, I will be set for my next opportunity. I couldn’t have been more wrong.

Fast forward a bit, and I drove to Houston with a packed car, with no place to live and only a vague idea of where I should look for apartments. I had no direction from the team, nobody checking in on me, and no help. I again had that strange feeling. Since this was my first time ever stepping foot in Houston, I realized it was going to take me a lot longer to find a place to live than I thought, I called the team the night I got there and asked them if they could put me up in a hotel for a day or two while I secured an apartment. They said: ‘we don’t really do that sort of thing, but good luck finding a place and let us know when you’re coming in’. 

It was right then where I thought ‘uh-oh’. 

It didn’t take long for me to really miss the Milwaukee Bucks staff, and for the next almost two years, I suffered through some of the worst and most frustrating moments of my career working for a group that was not aligned with who I am as a person or professional. I still think about that decision to this day, especially because it seemed so painfully obvious at the time. I knew the right thing to do, and I went in another direction.

As stock pickers, we want to do our very best to avoid having similar ‘uh-oh’ moments with our investments, but unfortunately, it will happen. When it does, it’s important not to ignore them. Uh-oh moments usually reveal themselves during due diligence, or as you get to know a business, and they will be painfully obvious, like my decision to choose between the people in Milwaukee vs. Houston. One group showed me they were great people with a great culture, the others did not. But like our rat mentioned above, the script I was following (work for and contribute to a good team, and you can get hired anywhere) caused me to run right past the obvious choice. 

I’ve had countless ‘uh-oh’ moments in my investing career, and at times I failed to act appropriately. Sometimes, uh-oh moments need to result in selling a stock. Sometimes they result in incremental due diligence to mitigate a risk, and sometimes, they are just short-term blips, like when a holding drops -20% after a less than stellar quarter. An uh-oh moment can also be thinking you ‘missed’ investing in a good business by not purchasing that stock that you passed on, because it’s up 20-40-60% from when you first passed (only to increase another 400% over time).  

It’s our job not to ignore the obvious when these situations arise. When I realized moving to Houston was a mistake, I spent plenty of time justifying my error. Well, the staff here is more accomplished. It will look better on my resume. The weather is nicer in Houston. Justifications like this get you killed in investing. So what you wrote a 40 page research report that took 60 hours of work? So what it’s your largest position? So what the stock is up +30% in two weeks? When that uh-oh moment comes, act accordingly. I couldn’t just pack my things and move out of Houston. But you can sell a stock in seconds. You can make a few due diligence phone calls. You can heavily add to a position when short term issues are clouding the picture. 

Years ago, I remember taking a due diligence trip to a remote town deep in the southeastern part of the US, to visit the operations of a $25mm microcap that I thought was my next big winner. In situations like this, when the company is trying to make it, manage costs and grow profitability, I expect everyone to be on the same page. Hungry, focused, and frugal. Let’s not act like we’ve accomplished anything yet. So when the CEO pulled up to the headquarters in a brand new Mercedes S500, I went, uh-oh. A few months later, the company lost their largest customer, kissing 60% of their revenues goodbye. Uh-oh. 

I’ll let you guess how the investment turned out. I found a way to justify my feelings along with the bad news and lost a lot of money. I failed to act when the opportunity presented itself, in two very obvious ways. 

Another instance involved me taking a trip to see the warehouse and distribution center of a sub-$200mm business. The investment was not going well. The industry hit a rough patch due to macroeconomics factors. There was a first-time CEO. The company was under investigation for unknown claims made by former employees. All uh-oh moments. I distinctly remember arriving at the facility that was supposed to be responsible for $500mm in sales. A small building with plenty of deferred maintenance that looked like it would struggle to do $5mm in sales. Uh-oh. 

I’ll let you guess how that investment turned out. I have plenty more examples. There are patterns here. Something is patently obvious. An uh-oh moment (or two) arrives. Either take action or suffer the consequences. 

Today, there is zero tolerance built into my process for unexpected uh-oh moments. Deceitful or lying management, a bad capital raise that wasn’t telegraphed in advance, or poor treatment of customers and employees are all signs that I need to move on.

When I launched my firm, the day one portfolio contained a company I was very excited about. Excellent business, good management, cheap valuation. As I got to know management better and as additional channel checks came back, my opinion changed. My spidey sense was tingling and the position was starting to keep me up at night in that I started to believe the CEO was the reason for the cheap valuation and that he would continue to hold the business (and their public market reputation) back. Shortly after, during a live earnings call, when asked to explain a revenue miss, the CEO proceeded to bash his entire salesforce for their youth and inexperience. All blame, zero accountability. This was a software business, so part of the thesis revolved around the company being able to hire talented and hungry salespeople to sign larger and larger deals. And the CEO just publicly torpedoed any chance of doing that successfully over time. Would you want to work for that guy? I sold out of our entire position the next day. 

There is a difference between good and bad uh-oh moments. The example above was a ‘shoot first, ask questions later’ situation that necessitated blowing out of our entire position. Earlier this year, however, one of my largest positions hit a quarterly snag and found itself down -30% within a span of two days following the issuance of softer than expected forward guidance. As a global electronics component manufacturer, this was during a period where the market was particularly sensitive to macro weakness, which affected the company given their end market exposure. However, this temporary slowdown was well telegraphed, and management did a great job of explaining that they may see some industry softness given the length of inventory destocking periods that are very common throughout the industry. I also had this as a key item in my pre-mortem for this business. ‘Expect some industry softness at some point, which will likely result in a tough quarter or two, and a buying opportunity.’ Despite the price action, the quarter itself was excellent, with ample cash generation, debt paydown, a share buyback program implemented for 5% of share outstanding, and a solid longer term picture. In other words, it was very clear that I needed to add to our holding. Following that uh-oh moment, I made it my second largest position. The stock is up +60% in the past six months. 

Today, thinking through and identifying potential uh-oh moments has become a big part of my investment process, and I highly recommend it for any investor. Also known as a pre-mortem, I like to write out or visualize waking up to significant negative news for one of my investments. Would I be excited? Would I want to immediately sell the stock? My answer to those questions can be very telling. In addition, it prepares me for that potential shock. With my electronic component manufacturer, I was ready. With my software business, I was watching management closely, and their actions triggered the immediate sell decision. 

With every investment, there are things you can’t control, so you need a plan for reacting to the unexpected. This is why research is important. This is why gaining conviction matters. Don’t fall prey to thesis creep, which uh-oh moments can introduce. Write down things that would make you change your mind about a specific investment. Then don’t ignore the obvious. That way, when you’re staring down the barrel of an uh-oh, you won’t just gulp. You’ll do something.

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