All of us know what a checklist is. Checklists are used in many places, e.g. in hospitals, in car repair shops and in event management. But in many places also in practically every company.
However, where does the checklist actually come from and why was it developed? In addition, how can we use the checklist approach for investing?
In this article, I would like to look at the origins and success story of checklists and also how we can use checklists in the investment process and build our own checklist.
What you will learn in this article
- How checklists came to be
- Why a checklist is so effective and works so well
- How we build an investment checklist and how we can develop it further
How checklists came into being
The first checklist
The checklist originated in aviation: During the Second World War, the US Air Force used the B-17, a Boeing aircraft, very successfully. In retrospect, this was a great success for Boeing. In 1935, however, it did not look as if Boeing would be able to land a major contract with its aircraft.
The first flight of the B-17 resulted in a crash in which three men were seriously injured and some even died. The plane crashed shortly after take-off. It turned out that the elevator did not react because the pilot had forgotten to release it.
In the end, however, it was not the pilot's fault or that the aircraft was too difficult to control. The aircraft and its functions were simply too complex for the human brain.
Therefore, the people at Boeing sat down and developed the first checklist for the plane. Today there are four checklists: one for take-off, one for the flight itself, one for landing and one for the stay on the ground.
We all know the result. Today, it is almost more likely that we will be hit by a bus on the road than that we will die in a plane crash. The airplane is an extremely safe means of transport.
For the airlines, a human life is extremely valuable. Every crash is very carefully analysed and the findings are directly reflected in adjustments to checklists, pilot training and aircraft equipment.
Therefore, the results of this approach are very convincing.
If you want to know more details about the history and use of checklists, you should definitely read the book Checklist Manifesto by Atul Gawande.
Why are checklists so effective?
Our brains are designed to take shortcuts wherever possible. We need simple and quick answers.
Back then, when our ancestors saw a wolf, a bear or a lion, they simply ran. There was no weighing up of different options. Basically, this has not changed until today.
In our decision-making processes, rationality and emotions are often mixed. For example, if we find a company that we think is undervalued, we inform ourselves about it, go through a series of questions and then often make a rather subjective decision based on our gut feeling.
In terms of process, this is quite ineffective, especially because a lot of it is quite random and intuitive.
A good checklist can help us here with three things:
- the checklist helps us not to take shortcuts and not to overlook things
- it helps us to structure the process properly and to look at the right things at the right time
- it helps us to control our emotions as much as possible or to take them into account as late in the process as possible.
How we build an investment checklist
Start with the strategies of the investment gurus
It is actually not difficult at all to build a good investment checklist yourself. However, it takes some time and requires some research.
First of all, we need a good starting point. What could be more obvious than to start with what we have learned from the well-known investment gurus and top investors like Benjamin Graham, Warren Buffett, Charlie Munger, Phil Fisher, Seth Klarman etc.? There are plenty of books and other information on the subject.
We could, for example, start analogous to Warren Buffett with the following 5 categories:
- Long-term economic characteristics
- Management skills
- Integrity of the management
- Purchase price of the share or valuation of the company
- Expected inflation and tax burden (to determine the required return - we can put this category in brackets for the time being).
We can then elaborate on these a little further, i.e. back them up with somewhat more concrete questions, e.g. those of Philip Fisher. Here are examples of the second and third levels for category 1, the long-term economic characteristics:
- Business model
- How does the company earn its money?
- What are the main products and segments in which the company is active?
- To what extent is the company regularly dependent on external capital?
- Positioning of the company in the market
- What is the competitive environment like?
- How great is the pricing power?
- Are there barriers to market entry?
- How are supply and demand developing?
- Competitive advantage
- Is there a sustainable competitive advantage?
- What is the nature of the competitive advantage or how sustainable is the advantage?
- What are the growth options?
- Resulting profitability of the company
- What do (equity) return on capital, return on sales, EBIT margin, free cash flow look like?
- Stability and solvency of the company
- How is the company financed?
- Are there covenants that must be met?
- What are the working capital requirements?
And so on. After this step, we should then have a first version of the checklist on which we can build further.
Analyse the mistakes of the investment gurus
Next, we can take a look at the mistakes made by the investment gurus and adapt and concretise the questions in our checklist accordingly. Of course, we should not ignore our own mistakes in the process.
The questions we should ask ourselves here are: What point did we overlook in our analysis? What point led us to misjudge a company?
For example, I once invested in Antofagasta plc a long time ago. However, when I analysed it, I was not so concerned with the copper market itself that I did not see that China was going to increase its demand for copper more and more (which it did). Since then, I have added an additional question on market and price trends to my checklist to cover this point.
Of course, it is much better (and cheaper) to start by analysing the mistakes of the investment gurus.
Warren Buffett, for example, once invested in a company called USAir, which in retrospect was a mistake. Buffett had focused too much on the long history of high profitability and too little on the important competitive advantage. Here is Buffett's comment from his 1996 shareholder letter:
"But my analysis of USAir’s business was both superficial and wrong. I was so beguiled by the company’s long history of profitable operations and by the protection that ownership of a senior security seemingly offered me, that I overlooked the crucial point:
USAir’s revenues would increasingly feel the effects of an unregulated, fiercely competitive market whereas its cost structure was a holdover from the days when regulation protected profits. These costs, if left unchecked, portended disaster, however reassuring the airlines past record might be." Warren Buffett
The questions we could add to our checklist here are: Is there a sustainable competitive advantage? Are there factors that could lead to the competitive advantage being lost? How likely is this scenario?
How we develop our checklist: Continuously incorporate our own experiences
Finally, we need to ensure that our checklist continuously evolves based on our day-to-day experience. The success of the big investors does not come by chance either, but is in most cases the result of many years of experience and, above all, the effective codification of this experience.
Here is another example, this time from Charlie Munger:
In 2000, Wesco Financial (Charlie Munger's firm, part of Berkshire Hathaway) acquired Cort, which was in the business of renting furniture. At the time of the takeover, Cort had above-average sales and cash flows, but these came about because of the Internet bubble and quickly collapsed after it burst.
Although Munger and Buffett knew that the internet bubble existed at the time, they overlooked the fact that it had temporarily had a strong positive impact on Cort's sales and cash flows.
So we can add the following question to our checklist in this case: Are the company's current revenues and cash flows sustainable or are they positively affected by, say, a temporary boom?
We also see: mistakes happen even to such experienced investors as Warren Buffett or Charlie Munger.
How we can use the checklist concretely
If we build our checklist according to the approach presented above, we will quite quickly have a relatively long list of criteria and questions that we want to answer for ourselves.
Mohnish Pabrai, well-known value investor and author of "The Dhandho Investor", for example, has so far (as of 2013) close to 100 items on his checklist. In addition, it supposedly only takes 15-20 minutes to go through the checklist once.
Presumably, however, no single company will meet all the criteria of such a detailed checklist and every potential investment will have a weak point somewhere. Moreover, there are also major differences depending on the industry. Health care companies function completely differently from companies in the aviation industry.
So the big question now is: how do we then derive a concrete investment decision from the findings of the checklist? Do we buy a share if, for example, 7 out of 10 criteria have been met or questions have been answered positively? Or do we need, for example, 10 out of 10 positive answers for a purchase decision?
Mohnish Pabrai gives a good example: Wells Fargo, in itself a good and stable business, failed the following criteria when analysed along the checklist:
- Too high leverage
- Potential negative impact of high unemployment or a recession
- Could make bad credit decisions (or has made bad credit decisions)
Pabrai now does not categorically exclude such investments, but helps itself with a scoring logic:
The companies that score high in all the categories (according to the Dhandho Investor there are 7 categories) on his Dhandho checklist get a higher portfolio allocation than the companies with a lower score, i.e. 10% versus 5% in the normal case versus 2% in cases like Wells Fargo. But I am not 100% sure if this is still Pabrai's allocation logic today, as Pabrai's portfolio is very concentrated today.
However, Mohnish Pabrai remains vague about the exact scoring and decision logic, just as he is vague about the concrete contents of his checklist. But this is understandable, as the checklist is, after all, his competitive advantage. Moreover, the checklist only acquires its real value when we create it ourselves.
"Most of the value of the checklist is the work that went into creating it. Just handing it to people is not going to help too much."
Checklists can also be very helpful in the investment context, see investors like Mohnish Pabrai and Guy Spier. To create our own investment checklist, we can proceed as follows:
- Use a list of key overarching categories from one of the successful investment gurus as a starting point.
- Further flesh out the list based on our own questions and ideas (add a second and third level)
- Analyse the mistakes of the investment gurus as well as our own and add appropriate questions to the checklist
- Continuously expand the checklist
In order to make the checklist useful for us, we should also develop a logic for deriving a purchase decision from the results of the checklist (e.g. a scoring logic).