Imagine going to a doctor with a stomach pain after you have been operated upon. The doctor asks you to get an x-ray done. The x-ray report shows a piece of sponge in your tummy.
Frightening, isn’t it? This could be life threatening.
As per a study done by the World Health Organisation, such medical mistakes result in around 7 million getting disabled every year. One reason this number is not higher is that doctors use what is known as a checklist before and after every operation.
Medical treatments have become so complex that it is difficult for doctors to keep personal check on each and every procedure. Mistakes still occur. But then the number of such mistakes is greatly reduced due to the use of such checklists. So, checklists save lives.
The US Air Force introduced the concept of checklists decades ago. These have enabled pilots to fly aircrafts at mind-boggling sophistication. Innovative checklists are now used in hospitals around the world. These help doctors and nurses respond to everything from common cold to epidemics. Even in the complex world of medical surgery, a simple 90-second checklist has cut the rate of fatalities by more than a third.
A fair amount of research has been done in the past that suggest the immense value of checklists. Checklists are valuable as these help short circuit the human brain in a way that it wants to work against us.
We generally are overconfident of our capabilities. A checklist can remind us that we are not infallible, that we do make mistakes, and not to be too sure about our decisions.
Investing in stocks is not as complex as doing a medical surgery or flying an airplane. But checklists play a very important role when it comes to investing in stock markets.
Charlie Munger, Warren Buffett’s partner at Berkshire Hathaway, can be credited of first introducing the checklists in investing. Munger talked about these in his book – Poor Charlie’s Almanack.
Here is a checklist I have prepared from my study of Munger’s checklists and that of other great investors like Warren Buffett and Philip Fisher.
The Investing Checklist
Step 1: Do the initial groundwork
- Read about the company – Company website, Google search, BSE announcements, Newspaper clippings
- Read about the competitors – Same sources as above
Step 2: Read past 5-10 years’ annual reports of the company
- Read the financial statements – Income statement, Balance Sheet, Cash Flow Statement
- Notes and Schedules at the end of financial statements
- Management discussion & analysis
- Management’s compensation – See for red flags like higher compensation as compared to industry, excessive bonus or commissions
- Promoter stake – Check shareholding over the past few years
- Read annual reports of the closest competitors and see for differences in tone and industry outlook
Step 3: Ratio analysis – Calculate the following ratios and the trend in the past
- Net-net working capital
- Free cash flow to EPS growth
- Free cash flow to sales
- Return on equity
- Return on invested capital (ROIC)
- Earnings yield (inverse of Price to earnings ratio)
- Inventory turnover and Receivables turnover
- Debt to equity
- FCF to debt
- Valuations – DCF, EPV
Step 4: Emotional Check
- Write down how you are feeling
- Write down the biggest reason you want to buy the stock
- Beware of wanting to just buy and study later
- See if you are being overconfident in your analysis
- Are you buying just due to amount of research you’ve put into the stock?
- Are you reluctant to accept differing opinions?
- Beware of buying just because others are buying the same stock
- Get away from the excitement and noise. If necessary, take a break and clear your mind.
Step 5: Final Evaluation
- What can go wrong?
- What will be you reaction if things really go wrong?
- What are the risks? How likely are the risks? How big are the risks?
- How attractive is this idea compared to the other holdings? Is that stock you already hold, better than this stock?
- What is your expected holding time frame?
- What price will you sell?
Done!
So here was the checklist that you must run through before making any investment decisions. And if you do your homework on this properly, you can rest assured that the stocks that pass this checklist will give you great return in the long run.
But there’s a caveat here – even if a stock passes this checklist and you go ahead and buy it, it is important that you run this checklist on that stock ever year to see if things have changed. That will keep you on your toes in case any adversity was to hit your stocks.
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