Lesson #20: Power of Investment Checklists
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 scissors 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
I. A Business You Understand
1. Do I understand this industry?
2. Is it industry within my circle of competence?
3. Do I understand this business?
4. How does the business make money?
5. How has the business evolved over time?
6. Does the industry have a high degree of change and obsolescence?
II. Good Long-Term Economics
1. Can the market for the company grow at above 10%+ per annum in volumes over the next 10 years?
2. Can the company grow its sales and profits at 15%+ and maintain ROE in excess of 20% for next 10 years?
3. Does the business have a sustainable competitive advantage and what is its source?
4. Does the business have high/low entry/exit barriers?
5. Does the business possess the ability to raise prices without losing customers?
6. What is the competitive landscape, and how intense is the competition?
7. Does the business enjoy power against its suppliers?
8. Has the recent good performance largely been due to a cyclical upturn in the
industry or is it sustainable?
III. Good Financial Strength
1. Has the company been growing its sales and profits consistently over the past 8-10 years? (Note – A new, small company can be growing very fast over the past 3-5 years, but may not be able to sustain that growth)
2. Has the company earned more than 15% ROE (consistently) over the past 8-10 years, and what has been the driver of the same (Du Pont analysis would tell you this)
3. Does the company have > 0.7 times debt/equity (Unless it is a bank / finance institution)?
4. Does the company have a large FCCB borrowing (foreign currency convertible bonds)?
5. Does the industry have high capital intensity (Sales / FA+NWC < 1.5 )?
6. Does the company earn rising and positive FCF? If not, does it have the
potential to do so in the future?
IV. Able & Trustworthy Management
1. Does the management have integrity – any anti-shareholder resolutions in the past?
2. Does the management discuss both negative and positives of the company performance candidly?
3. Has the management invested incremental cash at 15%+ ROE levels?
4. Is the management hoarding cash without raising dividend or reinvesting it?
5. Has the management done acquisitions in the past at high valuations and did they work out successfully? (Check goodwill write-offs)
6. Has the management used aggressive accounting in the past to manage results?
7. Does the management make more than 3% of net profit as salary?
8. Has the management been reprimanded by SEBI or other bodies. Does the management have a bad governance history with other firms? (check watchoutinvestors.com)
9. Does the company have opaque transactions with subsidiaries (check related party) and are transaction sizes big?
10. How many members of the promoter or family part of the Board of Directors? Does the family perform any useful role in management?
11. Has the management pledged more than 20% of shares? If yes, why?
12. Have the managers been buying or selling the stock?
V. Sensible Price Tag
1. Does the company sell at PE > 20x?
2. Does the current valuation assume growth in excess of the past or the same as past above average growth?
3. Does the company sell at huge discount to market or to other companies in the industry? Why?
4. Is the stock selling at 20-30% discount to your intrinsic value estimates as per the DCF model?
5. Is the market expecting a fast growth in earning going forward as per Stephen Penman’s Residual Earnings Model?
VI. Psychological Checklist
1. Social proof: Is this stock held by someone I like or admire and overoptimistic about it (not objective)?
2. Sunk cost fallacy: Have I held the stock for a long time and hence not ready to change opinion?
3. Is there performance envy involved? Others have done well with this idea and I have missed out on the gain?
4. Authority bias: Is this stock held by other investors I like and admire and is that influencing me?
5. Availability bias: Have I considered non annual report data, industry data and overall trends or only focussing on easily available information?
6. Recency bias: Am I giving more weight to recent data (check if the projections based on recent data or averages / look at 10-12 yrs data)
7. Confirmation bias: Have I checked for a similar company with identical economics which has not done well (in same and different industry). If yes, why did it not do well?
8. Am I too overconfident on the situation – assuming over-familiarity , associating positive unrelated feeling, too high weight to optimistic scenario ( familiarity due to work / association with the industry )
9. Have I done probability analysis for all negative factors
10. Am I having too much loss aversion – over-weighing negative factors?
11. Consistency bias: Am I slow in changing opinion – not responding to negative news?
12. Have I looked at the base case for the industry – Have majority of the companies in the industry created wealth?
13. Status quo bias: Am I unwilling to sell existing holding?
Overall, by building your own checklist — a standardized set of questions you must answer before you commit to any investment decision — you can reduce the risk of making costly errors. The best way to do that is by looking at your past mistakes.
It’s important to keep in mind that 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.