“No wise pilot, no matter how great his talent and experience, fails to use his checklist.”—Charlie Munger, Poor Charlie’s Almanack
“So you know, and all of these questions are not questions I created out of the blue. What I did is I looked at businesses where people had lost money.”—Mohnish Pabrai
Steve Forbes Interview With Mohnish Pabrai
A few years back, in 2010, Steve Forbes interviewed Mohnish Pabrai. This interview is about half an hour long, and among the topics discussed, checklists was one of them. The interview is available on YouTube, and there’s also a transcript available at Forbes’ – see here.
Below is an excerpt of the part of the discussion where Steve and Mohnish talk about checklists. Emphasis added by me.
Forbes: So in the first quarter of 2010, did you add any positions?
Pabrai: Yeah, actually, we did. We did find. In fact, there’s one I’m buying right now. But I found two businesses, but they’re anomalies. They were just, you know, businesses that had distress in them because of specific factors. And I think we’ll do very well on both of them. They’ll go nameless here. But no, I think, for example, in the fourth quarter of 2008 or the first quarter of 2009, you could have just thrown darts and done well. And that is definitely not the case today.
Forbes: And finally, telling you about mistakes, one of the things I guess an investor has to realize, they cannot control the universe. Delta Financial: You had done the homework, you fell and then events took it away from you.
Pabrai: Well Delta Financial was a full loss for the firm, for the fund. We lost 100% of our investment. It was a company that went bankrupt. And we’ve learned a lot of lessons from Delta. And one of the lessons was that Delta was, in many ways, a very highly levered company and they were very dependent on a functioning securitization market. And when that market shut down, they were pretty much out of business. And they were caught flat-footed. And so there’s a number of lessons I’ve obviously learned from Delta.
It’s easier to learn the lessons when you don’t take the hits in your own portfolio. But when you take the hits in your own portfolio, those lessons stay with you for a long time.
Forbes: So that gets to, you’re a great fan of The Checklist Manifesto. And you now have checklists. You said one of the key things is mistakes, in terms of a checklist, so you don’t let your emotions get in the way of analyzing. What are some of the mistakes on your checklist now that you go through systematically, even if your gut says, ‘This is great. I want to do it.’
Pabrai: Yeah, so the checklist I have currently has about 80 items on it. And even though 80 sounds like a lot, it doesn’t take a long time.
It takes about 30 minutes to go through the checklist. What I do is when I’m starting a business, I go through my normal process of analyzing the business. When I’m fully done and I’m ready to pull the trigger, that’s when I take the business to the checklist. And I run it against the 80 items. And what happens the first time when I run it, there might be seven or eight questions that I don’t know the answer to, which is great, which what that means is, ‘Listen dummy, go find out the answer to these eight questions first.’ Which means I have more work to do. So I go off again to find those answers. When I have those answers, I come back and run the checklist again. And any business that I look at is going to have some items on which the checklist raises red flags. But the good news is that you’re looking in front of you with all your facilities at the range of things that could possibly cause a problem.
And when you look at that list, you can also compare it to how those factors correlate with the rest of your portfolio. And at that point, kind of, you have a go, no-go point, where you can say, ‘I’m comfortable with these risk factors here. I’m comfortable with probabilities. And I’ll go ahead with it.’ Or you can say, ‘I’m just going to take a pass.’
And one of the things that came out of running the checklist was I used to run a 10×10 portfolio, which is when I’d make a bet, it was typically 10% of assets. And after I incorporated the checklist and I started to see all the red flags, I changed my allocation. So the typical allocation now at Pabrai Funds is 5%. And we’ll go as low as 2%, if we are doing a basket bet.
And once in a blue moon, we’ll go up to 10%. In fact I haven’t done a 10% investment in a long time. And so the portfolio has become more names than it used to have. But since we started running the checklists, which is about 18 months ago, so far it’s a zero error rate. And in the last 18 months, it’s probably been the most prolific period of making investments for Pabrai Funds. We made a huge number of investments, more than any other period, any other 18-month period in our history. So with more activity so far, and it’s a very short period, we have a much lower error rate.
I know in the future we will make errors. But I know those errors, the rate of errors will be much lower. And this is key. The thing is that Warren says, ‘Rule No. 1: Don’t lose money. Rule No. 2: Don’t forget rule No. 1.’ OK, so the key to investing is downside protection. The upsides will take care of themselves. But you have to make sure that your losers are few and far between. And the checklist is very central to that.
Forbes: Can you give a couple of the things that are on your 80 [item] checklist?
Pabrai: Oh yeah, sure. The checklist was created, looking at my mistakes and other investors’ mistakes. So for example, there’s questions like, you know, ‘Can this business be decimated by low-cost competition from China or other low-cost countries?’ That’s a checklist question. Another question is, ‘Is this a win-win business for the entire ecosystem?’ So for example, if there’s some company doing, you know, high-interest credit cards and they make a lot of money, that’s not exactly, you know, helping society. So you might pass on that. Also, a liquor company or tobacco company, those can be great businesses, but in my book, I would just pass on those. Or a gambling business, and so on.
So the checklist will kind of focus you more toward playing center court rather than going to the edge of the court. And there’s a whole set of questions on leverage. For example, you know, how much leverage? What are the covenants? Is it recourse or non-recourse? There’s a whole bunch of questions on management, on management comp, on the interests of management. You know, just a whole–on their historical track records and so on. So there’s questions on unions, on collective bargaining.
So you know, and all of these questions are not questions I created out of the blue. What I did is I looked at businesses where people had lost money. I looked at Dexter Shoes, where Warren Buffett lost money. And he lost it to low-cost Chinese competition. So that led to the question. And I looked at CORT Furniture, which was a Charlie Munger investment. And that was an investment made at the peak of the dot-com boom, where they were doing a lot of office furniture rentals. And the question was, ‘Are you looking at normalized earnings or are you looking at boom earnings?’ And so that question came from there. So the checklist questions, I think, are very robust, because they’re based on real-world arrows people have taken in the back.”
Disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company or individual mentioned in this article. I have no positions in any stocks mentioned.