Sunday, January 17, 2010

‘Airline pilot’ protocols in finance - By Atul Gawande

Thanks to Lincoln for passing this along!

Smart certainly isn’t the only one noticing society’s – and industry’s – resistance to change. Recently I’ve met three investors who have taken a page from aviation to incorporate formal checklists into their work. Mohnish Pabrai is managing partner in Pabrai Investment Funds in Irvine, California, and runs a $500m portfolio; Guy Spier is head of Aquamarine Capital Management in Zurich, a $70m fund; the third did not want to be identified or to reveal the size of the fund where he is a director. But it is one of the biggest funds in the world and worth billions.

These three people are value investors, buying shares in under-recognised, undervalued companies. They don’t time the market. They don’t buy according to a computer algorithm. They do intensive research, look for good deals, and invest for the long run. Over the past 15 years, Pabrai has made a new investment or two every quarter, and he’s found that each one requires in-depth investigation of 10 or more prospects. The ideas can bubble up from anywhere but most drop away after cursory examination. Every week or so, however, he spots one that starts his pulse racing. It seems surefire. He can’t believe no one else has caught on to it yet. It could make him tens of millions of dollars if he plays it right. “You go into greed mode,” he said. (Spier called it “cocaine brain”.) And that, Pabrai said, is when serious investors try to become systematic. They focus on dispassionate analysis, on avoiding both irrational exuberance and panic. They pore over the company’s financial reports, investigate its liabilities and risks, examine its management’s track record, weigh up its competitors, consider the future of the market it is in.

The patron saint of value investors, of course, is Warren Buffett. Pabrai has studied every deal Buffett and his company, Berkshire Hathaway, have made – good and bad – and read every book he could find about them. He even pledged $650,000 at a charity auction to have lunch with Buffett. “Warren,” Pabrai said – and after a $650,000 lunch, I guess first names are in order – “Warren uses a ‘mental checklist’ process” when looking at investments. So, that’s more or less what Pabrai did from his fund’s inception. And he did very well following this method – but not always. He also made mistakes, some disastrous.

These were not mistakes merely in the sense that he lost money on his bets or missed making money on investments he’d rejected. That’s bound to happen. These were instances where he had miscalculated the risks involved, made errors of analysis. For example, looking back, Pabrai noticed that he had repeatedly erred in determining how leveraged companies were. The information was available; he just hadn’t looked for it carefully enough. In large part, he believes, the mistakes happened because he wasn’t able to damp down the cocaine brain. No matter how objective he tried to be about a potentially exciting investment, he found his brain working against him, latching on to evidence that confirmed his initial hunch and dismissing the signs of a downside. “You get seduced,” he said. “You start cutting corners.” Or, in the midst of a bear market, the opposite happens. You go into “fear mode” and overestimate the dangers.

He also found he made mistakes in handling complexity. A good decision requires consideration of so many different aspects of a company in so many ways that, even without the cocaine brain, he was missing obvious patterns. His mental checklist wasn’t good enough. “I am not Warren,” he said. “I don’t have a 300 IQ.”

So he devised a written checklist.

. . .

Pabrai made a list of all the mistakes he’d spotted (even Buffet made them) as well as his own – about a dozen. Then, to help him guard against them, he devised a matching list of checks – about 70 in all. Similarly, the anonymous investor I spoke to – I’ll call him Cook – made a checklist. But he was even more methodical. He enumerated the errors known to occur at any point – during the research phase, during decision-making, during execution of the decision and even in the period after making an investment. He then designed detailed checklists to avoid the errors, complete with clearly identified pause points at which he and his team would stop and run through the items together. He has a Day Three Checklist, for example, by which time, the list says, the team should confirm that they have gone over the prospect’s key financial statements for the previous 10 years, including specifically checking for items in each statement and possible patterns across the statements. “It’s easy to hide in a statement. It’s hard to hide between statements,” Cook said.

One check requires the members of the team to verify that they’ve read the footnotes on the cashflow statements. Another has them confirm they’ve reviewed the statement of key management risks. A third asks them to make sure they’ve looked to see whether cashflow and costs match the reported revenue growth. “This is basic basic basic,” Cook said. “Just look! You’d be amazed by how often people don’t do it.”

The checklist doesn’t tell him what to do, he explained. It is not a formula. But it helps him be as smart as possible every step of the way, ensuring that he’s systematic about decision- making, that he’s talked to everyone he should. With a good checklist in hand, he was convinced he and his partners could make decisions as well as human beings are able. And as a result, he was also convinced they could reliably beat the market.

Cook would not discuss precise results – his fund does not disclose its earnings publicly – but he said he had already seen the checklist deliver better outcomes for him. He had put the checklist process in place at the start of 2008 and, at a minimum, it appeared that he had been able to ride out the subsequent economic collapse, avoiding disaster. Others say his fund has done far better than that, outperforming its peers.

After about a year working with a checklist, meanwhile, Pabrai’s fund was up more than 100 per cent. This could not possibly be attributed just to the checklist. With it in place, however, he observed that he could move through investment decisions far faster. As the markets plunged through late 2008 and stockholders dumped shares, there were numerous deals to be had. And in a single quarter he was able to investigate more than a hundred companies and add 10 to his funds’ portfolios. Without the checklist, Pabrai said, he couldn’t have completed a fraction of the analytical work or have had the confidence to rely on it. A year later, his investments were up more than 160 per cent on average. He’d made no mistakes at all.


In aviation, everyone wants to land safely. In the money business, everyone looks for an edge. If someone is doing well, people pounce like starved hyenas to find out how. Almost every idea for making even slightly more money – investing in internet companies, buying tranches of sliced-up mortgages – gets sucked up by the giant maw almost instantly. Every idea, that is, except one: checklists.

I asked “Cook”, our anonymous investor in Switzerland, how much interest others have had in what he has been doing these past two years. Zero, he said – or actually, that’s not quite true. People have been intensely interested in what he’s been buying and how, but the minute the word “checklist” comes out of his mouth, they disappear.

Even in his own firm, he’s found it a hard sell. “I got pushback from everyone. It took my guys months to finally see the value,” he said. To this day, his partners still don’t all go along with his approach and don’t use the checklist in their decisions when he’s not involved. “I find it amazing other investors have not even bothered to try,” he said. “Some have asked. None have done it.”


Book: The Checklist Manifesto: How to Get Things Right