Checklists are a normal way of life for many people, whether you’re an investor or otherwise. Over the years people from a multitude of industries and fields have utilised the effectiveness of simply making a list. From something as inane as a To Do list, that reminds someone of what they have to accomplish that day, to mandatory checklists that affect safety and ensure compliance; regardless of their use, everyone benefits. There is simply no down side to using one. However, not using a checklist, or failing to build a thorough or complete checklist, can have some rather disturbing consequences.
We know that all investors have biases, it's a function of human nature. When it comes to investing those biases can lead to sub-optimal returns, or worse, the permanent loss of capital. Many of the Investment Masters have turned to basic 'checklists' to help improve investment results. Charlie Munger, Warren Buffett's partner and one of the world's greatest investors, couldn't have been more definitive when he said: "If you're trying to analyze a company without using an adequate checklist, you may make a very bad investment".
No human is infallible, whatever they might think of themselves to the contrary. The better checklists include not only the things we know we need to investigate or analyse, but also the things we have learnt from past mistakes. This is crucial to success when using checklists; knowing what mistakes you or others have made should be a necessary or even mandatory inclusion. With that in mind, this then should become the first component when building your investment checklist – Start with both your own and any mistakes that others have made.
" …in terms of building checklists, there is no question that the place to go is past mistakes. Not only one’s own past mistakes, but also to look at other investors’ past mistakes and see what those mistakes were." Guy Spier
The more comprehensive your checklist is, the less likely you will forget things, and the more likely you will be to collect all the information you need. As no human is infallible, likewise no human being has a perfect memory. Even those lucky enough to have eidetic or photographic memories cannot remember everything – if its included in your checklist, and you follow your checklist religiously, quite simply it will ensure you remember to do it. Relying on memory alone is risky. How often have you woken in the middle of the night with a bright idea or a solution to a nagging problem, and then believing that you will remember it in the morning, have gone back to sleep happy and satisfied, only to wake in the morning and have forgotten what is it you thought of? The only sure way to remember it is to write it down. Basically, if it is in your checklist, you cannot forget it.
Compiling a checklist of potential items to systematically review will also help you avoid repeating mistakes. As Josh Waitzkin, noted in his excellent book 'The Art of Learning', "if a student of virtually any discipline could avoid ever repeating the same mistake twice - both technical and psychological - he or she would skyrocket to the top of their field."
The Investment Checklist should be designed to ensure critical information is collected, considered and not overlooked. It will guide the investor to areas where further research is required. A suitable investment is unlikely to require all check boxes be ticked, some checklist items are likely to be non-negotiable [e.g. too much debt, binary outcome, poor management history, etc.].
"…no investment is going to pass every single investment checklist item. What the investment checklist will do is to throw up issues that one should focus on." Guy Spier
'The first time I run the checklist it adds a lot of value because it highlights things that I don't know the answer to, and that leads to more research. The checklist is really good at highlighting the areas that could be problematic - things that I have missed etc, and then I can make a 'go' or 'no go' decision based on that." Mohnish Pabrai
Checklists are an ever evolving tool. Even those who work outside of investment, such as the pilots and surgeons we mentioned in Part 1, periodically add items to their checklists as learning, information or technology becomes available. If an aircraft crashes, the investigators explore the cause and make this known to all people involved with aeronautical safety. “The accident could have been avoided simply by doing X.” With that in mind, the learning is added into current pilot pre-flight and safety checklists, and essentially everyone learns from the mistake.
"Boeing just doesn't sit around in a room and come up with the checklist for take-offs. That has been created over 60-70 years of failures that have caused things to make the checklist. Our investment checklist was designed the same way. I looked at mistakes I made since the time I invested and I looked at mistakes that other people made that I respect like Warren Buffett and Charlie Munger, LongLeaf Partners and so on. When I look at mistakes, I would figure out what was the reason the investment lost money and was that reason visible at the outset? Was it visible before the investment was made. And, in most cases it's extremely obvious." Mohnish Pabrai
Similarly, the Investment Masters learn from their mistakes: "I learned that there is an incredible beauty to mistakes, because embedded in each mistake is a puzzle, and a gem that I could get if I solved it, ie a principle that I could use to reduce my mistakes in the future." Ray Dalio
"One learns the most from mistakes, not successes." Paul Tudor Jones
The checklist should constantly evolve as markets change and investors learn. It is also important that investments are continually reviewed against the checklist to ensure the original thesis remains intact.
“My good friend, Guy Spier, observed that both of us have a pre-investment checklist, but no in-flight checklist. The pre-investment checklist has proven invaluable. However, it is not enough to just keep up with ongoings in existing investments in an ad hoc manner. It is important to periodically run and re-run the in-flight checklist.” Mohnish Pabrai
Ultimately, the more layers of checklist redundancy an investor has in place, the less likely that the investor will make an error or omission.
Checklists can follow various forms and functions – you could have one to check all the information you need to collect when analysing an investment opportunity, or it could be a comprehensive list of actions which need to be completed prior to making an investment decision. Similarly, your checklist might be a set of benchmark criteria that determines a go/no go decision. You could have several that cover different investment processes such as short selling, risk-arbitrage or spin-offs. Whatever the case, the more checklists you employ in your investment activities, the more likely you will be to succeed.
"We have multiple checklists and processes in place to improve how we think and make decisions." Ken Shubin Stein
"What we’re starting to institute at our firm is for every function, including the investment function, to have a daily checklist.” Bruce Berkowitz
Checking off items ensures unsuitable investments are discarded quickly, increasing efficiency and allowing more time for finding/analysing attractive opportunities.
While it is common for investors to lose money by overlooking technical factors [such as operating leverage, too much debt, sovereign risk, technical obsolescence or a combination of factors], often such mistakes are the result of psychological biases. These psychological biases tend to be less obvious, even in hindsight, to an outside observer. The checklist can be developed to create awareness of, and overcome, common psychological biases such as commitment bias/groupthink/herding/anchoring/recency bias, etc.
"In the checklist, it’s possible to put not only the steps necessary to do the research as well as lists of mistakes or problems that occurred in the past and should be avoided, but also a list of cognitive biases. This allows the investor to check with him or herself and to think about whether there are forces at play that may be activating some cognitive biases, and if so, to consider those." Ken Shubin Stein
“My checklist is.. is it cheap? is it a good business? who is running it? and what did I miss? I go through all the checklist. When I go to ‘what did I miss?’ .. it is hugely important to understand psychology and human cognition.” Li Lu
Whilst checklists are a vital part of any investment activity, they should not replace your own thinking. As we learnt from Part 1 on this topic, the mind plays tricks on us or we are wired to avoid certain information that is contrary to our opinion. With that in mind, you can avoid the mind games by including points in your checklist that encourage you to look beyond what you see, to challenge your opinion or that held by others, and to explore the topics that you might otherwise overlook. In short, to be creative in your thinking. Whilst checklists should not replace your thinking, they should be in place to ensure you think the right way.
"A checklist is no substitute for thinking." Warren Buffett
"Doing something according to pre-established rules, filters, and checklists often makes more sense than doing something out of pure emotion. But we can't have too many rules, filters or items without thinking. We must always understand what we're trying to accomplish." Peter Bevelin
Below I've included a SIMPLE checklist framework I've built. It's far from finite but may assist as the foundation for further development. I've added links to the appropriate 'Investment Masters Class' tutorials so you can consider the Investment Masters thoughts on the topics to further expand the checklist items.
EXAMPLE CHECKLIST ITEMS
- Is there risk of permanent loss of capital? [eg debt, fraud, disruption, obsolescence, operating leverage, high valuation, sovereign risk, regulatory risk, patent/lawsuit loss, closed credit markets, systems failure, natural hazards, commodity price collapse/spike, debt re-financing, large risky acquisition, derivative/FX/interest rate risks, project risks, contract loss, brand damage etc].
- Do I understand the business? Does it have a reason for being? Why does the customer buy? Could customers operate if the company disappeared tomorrow? Is it within my circle of competence?
- Is the stock liquid? Can it be a reasonable size in the portfolio?
- Is the leverage appropriate?
- Is it cheap/fairly priced? Does it offer asymmetric returns? Downside risk versus upside risk?
- Is it a quality business? moat (expanding?), pricing power, margins, track record/long term?, market share/potential/international, cash flow conversion, high return on capital, reinvestment opportunities, corporate culture, industry structure, rational/few/many competitors, innovation, fragmented/concentrated customer/supplier base, single product/commodity/lifecycle? win-win industry, capital requirements to grow?
- Is the business unique? Differentiated business model, culture, market access, structure?
- Does the crowd love the stock? or is it hated?
- Quality of management - capital allocation, honesty, track record, incentives, skin in game, innovation, conservative accounting?
- Can the business compound capital? Are there opportunities to re-invest capital at attractive returns?
- Can the business grow revenue? What tailwinds/headwinds? What incremental costs?
- Potential for technical disruption/obsolescence?
- How hard is it to replicate the business? Can competitors copy the business?
- What is business likely to be doing in next 5-10 years? How has it changed in the last 5-10 years?
- Has the business been stress tested? Track record of earnings, margins? How did company fare in Financial Crisis?
- Does the business have hidden asset value? Is the business under-earning? ex or cum-capex?
- What are the key drivers for the business?
- What does the industry capital-cycle look like, consolidation or expansion?
- Is the stock likely to be mis-priced? Why does the opportunity exist? What is the edge?
- What is the intrinsic value? Is the price reasonable/cheap vs intrinsic value?
- What is private market value? Is the company a potential target?
- What are the implied growth rates in the current share price? How does it compare to peers?
- How confident can you be about earnings in 3-5 years time?
- Is there a margin of safety?
- What does the register look like? Have insiders been active?
- Are there any catalysts?
- Cross-checked/information sought from customers/suppliers/competitors etc?
- Have alternate outcome been considered? What could go wrong/kill the business? What is the counter-argument? What are the consequences of being wrong?
- What cognitive biases could be influencing decision?
- What don't I know?
Once the investment passes the checklist, it's time to consider a portfolio management checklist. How big should the position be? what will the impact be on portfolio correlation? How will the position impact portfolio liquidity? What will be the impact on portfolio exposures - industry, FX, ETF exposure, geographic diversification? What percentage of the stock will the holding represent? What are the hidden correlations across the portfolio? etc.
Investors should give consideration for (and continue to adapt) the length and order of their checklist. For better or worse, the more time you spend on an investment the more likely you are to invest. Your time is in finite supply and average investments are in high supply, so have the diligence to move on to the next prospective investment with a preference for investment mistakes of omission rather than commission - be determined to wait for a fatter pitch. One approach may be ranking checklist items, ie. with non-negotiables at the top to act as a quick filter. Another approach, may be taking a first pass at all checklist items with the goal to reject the investment, then if it fails to be rejected, performing a deeper dive on the company.
To get the most out of your own checklist, (recommended for an in depth analysis) items can be written and answered such that;
• They elicit an ex-ante statement from you for the basis of your investment (you can then compare ex-post for your inflight checks.. or air crash investigation)
• You are forced to consider both the outside view (industry base rates and competitors) and the inside view (your experience - both vicarious and direct)
• You must consider the inverse, what would the opposite look like, how could you be precisely wrong
• You list what psychological forces can affect your conclusion for each item (see Charlie Munger’s two track analysis)
The best investment ideas often come from creative thinking when a combination of ideas develop and combine to provide an insight other haven't considered. Explicitly considering each checklist item aids this process.
"If you’ve got a full list of tools, and go through them in your mind, checklist-style, you will find a lot of answers that you won’t find any other way.” Charlie Munger
So are you using checklists? If you are, do they include all the necessary points for success in investing? Challenge yourself to review your lists regularly. Don’t fall into the trap of thinking what you have will always serve you well. Evolve your lists, add to them, alter them, delete obsolete or flawed points. The better the lists, the better they will serve you in your investment activity.