Final Decision Checklist

I had previously mentioned a checklist that I use as the last thing I look at before making an investment in a stock. As I'm thinking about spelling out my process and philosophy in regards to forming a potential Registered Investment Adviser, I thought I'd clean up the wording a bit, and paste it here if anyone else is interested. One important note though: I've come to believe that developing a full image in one's mind of how a business operates, competes, allocates capital, takes care of customers, etc. is much more important than checking off certain items on a list (i.e. Holograms > Checklists). Combined with developing that image is the necessity of only investing in those things that seem like obvious bargains. But the final checklist serves as a great way to help stay disciplined, and hopefully sidestep some avoidable errors. Everyone's will probably be different and evolve over time, but here is mine in its current state.

Final Decision Checklist (the final checklist to go through before putting any capital to work)

1. Are you tired?

• "We didn’t know, when we started out, this modern psychological evidence to the effect that you shouldn’t make a lot of important decisions when you’re tired and that making a lot of difficult decisions is tiring.... I cannot remember an important decision that Warren has made when he was tired." –Charlie Munger

2. Did you make this investment decision while the market was closed, so that current price moves aren't impacting your judgment?

• “Sleep on it” is good advice before buying/selling.

3. Have you done enough work, and are you sure this is within your circle of competence? 

• "We will never buy anything we don’t think we understand. And our definition of understanding is thinking that we have a reasonable probability of being able to assess where the business will be in 10 years." –Warren Buffett

4. Is the balance sheet conservative to allow the company to endure—and hopefully take advantage of—even the most difficult of economic environments?

5. Is the management team comprised of the kind of people you want to partner with, and are their interests clearly aligned with your interests? It’s not worth being business partners with people you don’t like and admire, and as an owner of the business they are running, you are essentially their partner.

6. Is this a good business? 

• It doesn't necessarily have to be a long-term "compounder" type of business, but it needs to provide real value for its customers, clients, etc…. i.e. a Win-Win with all six counterparties (customers, suppliers, employees, owners, the regulators, and the community).
• “Win-win is as much safety as it is compassion. The sustainability of any organization ultimately rests on delivering a win-win partnership with counterparties. Any other relationship will eventually lead to a fatal flaw that will eventually be corrected. Be constant – Be Kind.” –Chris Begg

7. Do you have downside protection? This will largely come from:

• Paying close to (adjusted) net asset value, encompassed within a business that has solid earning power (even if temporarily obscured) and some advantages protecting that earning power, even if it’s within a cyclical business and the size of the moat may be hard to estimate.
• And/Or a moat that protects a minimum, and conservatively-estimated, level of earnings—and then paying a fair to good to great price for that level of earnings. The price paid will largely be a judgment call based on the size of the moat and the reinvestment prospects within that moat (i.e. ability to invest capital at high rates for a given duration of time).
• The direction of the moat (shrinking or expanding) is more important than the size of the moat.
• “We think in terms of that moat and the ability to keep its width and its impossibility of being crossed as the primary criterion of a great business. And we tell our managers we want the moat widened every year.” –Warren Buffett
• “In my view, widening the moat is more important than the width of the moat. Everyone is attacking a company’s moat, so the question is not how wide it is, but whether it is widening at a faster pace than competitors are filling it up. Innovation is central to the idea of widening a moat.” –Rob Vinall
• And while a judgment call on quality vs. price, remember that it should look obvious if you have a full picture of things: “Part of the reason that we have a decent record is [that] we pick things that are easy. Other people think they're so smart they can take on things that are really difficult. That proves to be more dangerous. You have to be shrewd, and you have to be very patient. You have to wait until something comes along which at the price you're paying is easy.” –Charlie Munger

8. When thinking about price vs. value: 

• Is there at least three times more upside than downside? (e.g. If downside under a worst-case scenario is 50%, I need at least 150% [2.5x return] upside.) 
• Do I think this investment is likely to double in 3-5 years? (~15-26% IRR)
• And if I'm wrong, is there a high probability that my downside is waiting 10 years (because it’s a good business that is growing) for a double as opposed to losing money? (~7% IRR)
• There may be some situations where your downside is so limited if you can hold longer-term that even if the expected IRR may be 15% over a 2-3 year period instead of longer, it could still be worthwhile (e.g. A bond you know with extremely high confidence will pay off at maturity, and you can hold until maturity; Or at times, buying Berkshire Hathaway at a low multiple of understated book value, and also a decent discount to fair value.).
• One of the main advantages you can have as an investor is looking out 5-10 years when thinking about value—as opposed to thinking shorter-term—and comparing that value to the price today.

9. Is this business almost certain to be making more money 10 years from now, and can it increase its long-term value in a tough economic environment (e.g. by buying stock, taking business from weaker competitors, treating weaker customers and suppliers well in order to build long-term trust, etc.)? 

• Downside via a current moat or asset value isn't enough…. The business must also be something that is almost certain to be making more money in 10 years. All six key investment traits should be present—to varying degrees and sometimes temporarily obscured (unless it’s a special situation investment with a given catalyst):
• Downside 
• Cash Flow (Sustainable Earning Power) 
• Growth (Reinvestment Opportunities)
• Antifragile (ability to take business advantage in tough environments—including high inflation—even though the stock may go down with a declining market)
• People 
• Price

10. Am I viewing this as a business and not just a stock? Am I taking the mindset of buying the business outright, and retaining management?  

• "[Charlie and I] don’t consider ourselves richer or poorer based on what the stock does. We do feel richer or poorer based on what the business does." –Warren Buffett

11. Am I sizing the position appropriately? 

• While you need to concentrate your portfolio in your best ideas, you also need to remember Howard Marks' story about the race with one horse, where what seemed like a sure thing wasn't, because the horse jumped the fence and didn't finish the race..... Unexpected things happen and you won't see them all coming. 
• The Marks story, via Peter Bevelin's All I want to know... book: “It can always get worse than you think. I love this story from Howard Marks: ‘I tell my father’s story of the gambler who lost regularly. One day he heard about a race with only one horse in it, so he bet the rent money. Halfway around the track, the horse jumped over the fence and ran away. Invariably things can get worse than people expect. Maybe ‘worst-case’ means ‘the worst we’ve seen in the past.’ But that doesn’t mean things can’t be worse in the future.’”
• And it may not be a bad idea to only buy 1/3 of a position at first, especially if you've been following the company for less than 6 months. 

12. No FOMO, No Sunk Costs, and No Acting Out of Boredom.

• You have to be willing to watch plenty of things you thought were good but not good enough go on to perform well and be indifferent about it; that’s part of the game. 
• You can’t let putting time and effort into something influence your willingness to invest in it—be ready to walk away and move on, with equanimity to the eventual outcome, as soon as you see something that you don’t like. 
• And always do the work before investing, realizing that you’ll miss plenty of things that go up while you’re finishing the work that needs to be done before investing in anything.
• So, have you done the work that needs to be done? And are you sure you’re not settling just because you’ve put in the work?
• And remember, great investors have often made mistakes when they either had little to do (do-something syndrome) or had too much cash on hand. You must stay disciplined, and then remain patient for however long it takes.

Not making a decision while tired

I've been updating a short checklist that I created to use as the last thing I look at before making an investment in something. These kinds of checklists are best kept short, and mine currently consists of 12 items. There is one question I've added that may seem obvious, but that I decided is best to physically make myself confirm before investing:

• Are you tired?

This was inspired by re-reading a Charlie Munger comment:

"We didn’t know, when we started out, this modern psychological evidence to the effect that you shouldn’t make a lot of important decisions when you’re tired and that making a lot of difficult decisions is tiring....  I cannot remember an important decision that Warren has made when he was tired."

Obvious? Probably. But its simplicity doesn't make it any less important.

Links

"We generally believe you can just see anything in markets. I mean, it's just extraordinary what happens in markets over time. It gets sorted out eventually, but we have seen companies sell for tens of billion dollars that are worthless. And at times, we have seen things sell for...literally 20 percent or 25 percent of what they were worth. So we have seen and will continue to see everything. It’s just the nature of markets. They produce wild, wild things over time. And the trick is, occasionally, to take advantage of one of those wild things and not to get carried away when other wild things happen because the wild things create their own truth for a while." --Warren Buffett (2000)

Links to some old Ben Graham articles (via Twitter) [H/T @jasonzweigwsj] (LINK)

Mohnish Pabrai interview in The Economic Times (LINK)

The checklist that I created came out of looking at mistakes made by great investors. The single biggest reason why investments don’t work out for investors is leverage. The second biggest reason has to do with a misunderstanding of the comparative advantage of the moat. Then you get to management and ownership and other issues. You might get to environmental or unions and labour and that sort of things. The three really big things are — leverage, moats and management, probably in that order. 

More than money, Berkshire’s Todd Combs coming on Paytm board is the best outcome (LINK)

The Race of Our Lives Revisited (in a nutshell) - Jeremy Grantham (LINK)

In this abridged version of “The Race of Our Lives Revisited” Jeremy Grantham provides a detailed discussion of the long-term, slow-burning problems that threaten us today: climate change, population growth, increasing environmental toxicity.

Citron Research's short thesis on Wayfair (LINK)

Akimbo Podcast: Ignore sunk costs (LINK)

Radiolab Podcast: Baby Blue Blood Drive (LINK)

Does Our Cultural Obsession With Safety Spell the Downfall of Democracy? (LINK)

Fred Rogers: a quiet psychological revolution in children’s television (LINK)

Related book: The Good Neighbor: The Life and Work of Fred Rogers  

Related documentary: Won't You Be My Neighbor?

Links

"The notion of 'Keep Showing Up.' I wish I would have got that earlier, because I think it would have been easier to endure through some very difficult periods of time. I wish I would have learned that early in my business career.... I would have liked to have somebody tell me: 'Paul, keep showing up.'" --Paul Black [when asked about what life lesson he wished he'd have learned earlier in life, via the podcast below]

Capital Allocators Podcast: Paul Black - Gratitude, Fun, and Growth Stocks (LINK) [There is a great discussion on assessing company culture starting at the 17:50 mark, as well as a recommendation of the book The Culture Cycle. His example describing Whole Foods' culture as having an 'absence of fear' reminded me of some of Peter Kaufman's comments about the importance of trust—among businesses, relationships, and puppies.]

Mohnish Pabrai, Guy Spier and Raamdeo Agrawal interviewed by ET Now at the Berkshire Hathaway Annual Meeting (video) (LINK)

Nobody Planned This, Nobody Expected It - by Morgan Housel (LINK)

“Principles for Success”: an ultra mini-series (about 30 minutes total) overview of Ray Dalio's ideas (LINK)

Tech’s Two Philosophies - by Ben Thompson (LINK)

a16z Podcast: The Case Against Education, From Signaling to Rainbow’s End (LINK)

Related book: The Case against Education

Surgical Checklists Save Lives — but Once in a While, They Don’t. Why? - by Siddhartha Mukherjee (LINK)

Ebola Returns Just as Trump Asks to Rescind Ebola Funds - by Ed Yong (LINK)

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 constituents to be sustainable over the long term (customers, suppliers, employees, owners, regulators, and communities).
• “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