Sunday, January 31, 2016

Key Checklist Items

In his review of Atul Gawande's book The Checklist Manifesto a few years ago, John Kay wrote:
Mr Gawande discovered that the good checklist is short but not too short. If the list is long, none of the items on it are taken very seriously. You can easily persuade people to agree to things when you ask them to mechanically click or tick their way through a list of questions. Consider the lack of attention you give to the many privacy questions asked by websites or questions on an immigration form. It turns out you can easily persuade people to declare their involvement in genocide or intention to subvert the constitution of the US by inserting the relevant question in a long list of immigration queries, all of which expect the answer yes. 
So the good checklist is selective – it doesn’t cover mistakes that are rarely made; no one goes on holiday without their suitcase. Or mistakes that don’t matter – toothpaste is available almost everywhere. 
Flying – and surgery – lend themselves to checklists because there is a large element of routine, and because the consequences of an elementary error can be devastating. The first factor makes it possible to compile a useful list, the second encourages people to use it. 
But Mr Gawande’s most important discovery was that the power of the checklist came from a less obvious source. The list empowers members of a team to monitor each other. Adherence to the list allows the nurse to correct the surgeon, the co-pilot to review the captain. The successful travel list is likely to be a family rather than an individual endeavour.
Many investors (myself included) believe checklists can be powerful tools in the investing process. Warren Buffett and Charlie Munger keep it simple and don't use a physical checklist (and didn't even before decades of experience made their process routine), while other investors like Mohnish Pabrai and Guy Spier have discussed their use of a physical checklist. Mr. Buffett's checklist/filter was summed up pretty well in this excerpt from Peter Bevelin's book Seeking Wisdom:
At a press conference in 2001, when Warren Buffett was asked how he evaluated new business ideas, he said he used 4 criteria as filters.
  • Can I understand it? If it passes this filter, 
  • Does it look like it has some kind of sustainable competitive advantage? If it passes this filter,
  • Is the management composed of able and honest people? If it passes this filter,
  • Is the price right? If it passes this filter, then we write a check
For my part, I've been experimenting with a combination of the two over the last few years. At first I started just developing a physical list, but it started to become too long because there were many examples I wanted to include, as well as other longer excerpts of things I wanted to include to help me think about a potential investment (examples are things like book passages on the capital cycle or the importance of focusing on expected returns when investing in a business with a moat).

So what I've done is create a document with a bunch of checklist-type questions as well as passages of things I want to review continually over time. I mentioned this at the end of my post on fundamentals, and it has now taken the place as being the thing I review a little bit of almost every day. I still try and read a little bit of all the books mentioned in that post, but now I do that about every week or so instead of doing it as often as before since I've moved many of the key ideas into the compiled document, which now stretches over 100 pages long.

I also continue to practice the routine I described in my post on memortation. This not only helps keep the important things almost always near the top of my mind, but it also provides a nice way for me to get focused in the morning and to get refocused when my mind begins to stray.

And then for practical and idea-specific investment use, I've spent a little time trying to focus on the key ideas to have something that can practically be reviewed and thought about, either by myself or with others before committing capital to an idea. This is an evolving list and will pretty much be different for each individual person to fit one's own preferences and philosophies. And for teams, the checklist may need to be even more simple because I think the best results come from a list that everyone both believes in and is fanatical about executing; which in the case of investing means everyone is fanatical about finding ideas that meet the criteria

Below is a current list I have together that I've found useful for myself. It will likely change a bit over time, and it probably isn't right for you. In fact, it is almost guaranteed not to be right for you. But it may be useful for some, and may give readers of this an idea for their own list, so I decided to post it. 


Key Checklist Items

What’s the downside?

What’s the case for having a reasonable expectation of making a 26% IRR (i.e. a double/100% return in 3 years, or a 2.5x/150% return in 4 years)? While the actual expected return can be less if there is adequate downside, you want there to be a reasonable chance it can produce this IRR.

If I need to get out of this because I am wrong, what will be the likely reason I was wrong on it (i.e. do a pre-mortem)?

Are you sure this is within your circle of competence? What work have you done? Do you understand how the company stands in its industry and versus its key competitors? And remember to never underestimate competition, and that high returns tend to attract competition ‘like a moth to a flame’, and this includes businesses and entrepreneurs that aren’t even competitors yet.

Is my upside 3 times greater than my downside? (And since most investments can be down at least 50% due to the unknown unknowables, you need to really look hard for growing businesses that you think will be worth about 2.5x where you are buying them over a 4-7 year period. And remember that growth can both create and destroy value, so it needs to be economically profitable growth).

“Your goal as an investor should simply be to purchase, at a rational  price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now.  Over time, you will find only a few companies that meet these standards - so when you see one that qualifies, you should buy a meaningful amount of stock.  You must also resist the temptation to stray from your guidelines:  If you aren't willing to own a stock for ten years, don't even think about owning it for ten minutes.  Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio's market value.” –Warren Buffett (1996 Letter to Shareholders) [emphasis mine]

Is the business a good business?
  • Does it earn high returns on capital?
  • Does it have a long runway of reinvestment prospects? (Look for businesses that can at least double revenue per share in 10 years, and preferably businesses that can increase revenue per share 3-4x, with profit per share increasing even more.)
  • Does it have a moat that protects those returns from competition and allows reinvestment to also occur at a high rate?
  • Prefer a business that does not require a lot of capital to grow (i.e. not too capital intensive) where much of the growth will be due to the company’s own actions (instead of relying on things like commodity prices, interest rates, etc.).
  • The business needs to be in a Win-Win relationship with all of its counterparties to be sustainable over the long term.
  • “A dreamy business offering has at least four characteristics. Customers love it, it can grow to very large size, it has strong returns on capital, and it’s durable in time – with the potential to endure for decades. When you find one of these, don’t just swipe right, get married.” –Jeff Bezos

Does it have a good balance sheet?
  • Is there a conservative level of debt (and preferably, no debt)?
  • Are there any off-balance sheet liabilities that I need to account for?
  • Is the balance sheet structured to allow the company to take advantage of unforeseen opportunities or market crises should they present themselves?
  • You want a company that can control its own destiny and not depend on the kindness of strangers (for access to capital, debt rollovers, etc.).

Does it have good management?
  • Look for “intelligent fanatics” who are owner-operators, and where the ownership was preferably gained through buying in the open market or from founding the company, as opposed to option grants where they got the upside without the corresponding downside risk.
  • You want management teams with intelligence, integrity, and energy that pursue excellence in everything they do (products, people, etc.).
  • Does management understand capital allocation? Management skill in allocating capital is extremely important.

Is it trading at a good price?
  • Is there a significant margin of safety? You need margin for error, because you are bound to make plenty of errors over time. So always consider the question, what if I’m wrong?

Is this a good addition to a portfolio goal of having 6-12 mostly non-correlated positions (where a position may hold more than one stock if there is high correlation among certain ideas and they look about equally attractive to purchase together).

When looking at a potential business, you need to take the mentality of buying the entire business, and retaining management. If you are buying the business as your only family asset and have to keep these people running it, how comfortable are you buying the business at this price? Make sure you are taking a fundamental, entrepreneurial view of the business and NOT an MBA/outside-investor-know-it-all type of view.

What are the 1-3 main things that will drive this business, and what data can I use to track them over time?

If you talk to management, see if you can get answers to the following:
  • If you went away for 5 years and could only get updates on 1-3 business metrics to tell you how the business was doing, what would those key metrics be?
  • (After assuring them their answer would be kept private…) If you had to buy the stock of any company in your industry, excluding your own, what company would it be, and why?

………………..

"Our strategy remains to own the best companies in worthwhile fields. Our companies retain an abundant potential for growth, an ability to withstand adversity, a lowish valuation, a low likelihood of the business becoming obsolete, and managements that have a record of creating franchises out of thin air. We don't focus excessively on stock prices, because we know that if our companies are gaining on competitors, building up cash and paying off debt, lowering their cost structures, and otherwise better positioning themselves for the next upcycle, we will eventually be pleased with the outcome." -Greg Alexander