“A checklist is a way of managing your own mind and guarding against your own proclivities, so it needs to be based on this kind of self-awareness.” ―Guy Spier, The Education of a Value Investor
Investment Checklists and Surgeons
In The Education of a Value Investor Guy Spier discusses the subject of checklists, and how to develop and use them in investing. This is the main subject of chapter 11―An Investor’s Checklist: Survival Strategies from a Surgeon. Spier shares some of his own insights and his view of checklists as a tool to prevent investors from making mistakes.
What’s the Use in Using an Investment Checklist?
Let’s consider a few points before moving on, to get a quick refresher on the subject of investment checklists, and why a checklist could serve you as an investor good in your investing process.
All quotes below are taken from Guy Spier’s book as referred to above.
Who? An investment checklist for you yourself as an investor.
“…it’s important to recognize that my checklist should not be your checklist.”
What? An investment checklist containing broader categories (“including themes such as leverage and corporate management”) made up of individual checklist items (such as “has this management team previously done anything self-serving that appears dumb?”).
“…design checklist items that would help to prevent us from repeating […] mistakes.”
When? As a tool to be used before we make a final decision to buy or not buy into a certain business.
“Before pulling the trigger on any investment, I pull out the checklist from my computer or the filing cabinet near my desk to see what I might be missing.”
Where? As an integral part of your ongoing investment process, and as a tool in your business analysis and investing.
“The checklist is invaluable because it redirects and challenges the investor’s wandering attention in a systematic manner. I sometimes use my checklist in the middle of the investing process to deepen my understanding of a company, but it’s most useful right at the end as a way of backstopping myself.”
Why? Minimize the probability of permanent loss of capital. Our mind sometimes plays tricks on us and we better watch out and do our best to mitigate these so-called biases (or heuristics) that affects our decision making. As Warren Buffett once said: “Rule No. 1: Never loose money. Rule No. 2: Never forget rule number one.”
“The brain is simply not designed to work with meticulous logic through all of the possible outcomes of our investment decisions.”
“The goal in creating a checklist is to avoid obvious and predictable errors.”
“…the items on [pilots’] checklists are designed to help them avoid mistakes that have previously led to plane crashes. In investing too, the real purpose of a checklist is to serve as a survival tool based on the haunting remembrance of things past.”
An Investment Checklist as a Way to Avoid “Cocaine Brain”
Spier talks about a certain problem, a mental state that he refers to as the “cocaine brain” and explains as…
“…the intoxicating prospect of making money can arouse the same reward circuits in the brain that are stimulated by drugs, making the rational mind ignore supposedly extraneous details that are actually very relevant. Needless to say, this mental state is not the best condition in which to conduct a cool and dispassionate analysis of investment risk.”
To keep it simple. Each checklist item you chose to put up on your checklist, you include for one reason, and one reason only. That is, to avoid the cocaine brain mental state, and to make your best effort in trying to make sure not to break the two rules mentioned above by Buffett.
Checklist Items: The Warren Buffett Way
The Oxford Dictionaries defines the word “Checklist” as:
A list of items required, things to be done, or points to be considered, used as a reminder. (Source: Oxford Dictionaries)
As any checklist, an investment checklist is often made up of individual checklist items, that together constitute broader categories, that in turn form the checklist as a whole. Let’s look at an example to see what these broader categories may look like, by looking at a well-known quote from Warren Buffett taken from his 1977 letter to shareholders, where he lays out four things that he looks for in a business (emphasis added).
“We select our marketable equity securities in much the same way we would evaluate a business for acquisition in its entirety. We want the business to be (1) one that we can understand, (2) with favorable long-term prospects, (3) operated by honest and competent people, and (4) available at a very attractive price. We ordinarily make no attempt to buy equities for anticipated favorable stock price behavior in the short term. In fact, if their business experience continues to satisfy us, we welcome lower market prices of stocks we own as an opportunity to acquire even more of a good thing at a better price.”
The quote above contains four points (or broader categories): 1) an understandable business, 2) favorable long-term prospect, 3) honest and competent people, and 4) an attractive price. For each one of these points one needs to determine what factors (individual checklist items) to consider to be able to reach a conclusion. Another quote from Buffett could give some advice on what to look for when evaluating management (emphasis added).
“Passion is the number one thing that I look for in a manager. IQ is not really that important. They need to be able to work well with others and the ability to get people to do what you want them to do. I’d say intelligence, energy, integrity. If you don’t have the last one, the first two will kill you. All you have is a crook who works hard. If a person doesn’t have integrity, you want them dumb and lazy.” (Source: Buffett FAQ)
And how could you find the information you need to make a judgement call like this? Again, let’s turn to Buffett for some advice (emphasis added).
“Almost everything we learn is from public documents. I read Jim Clayton’s book, for example. There is adequate information out there to evaluate businesses. We do not find it particularly helpful to talk to managements. Often managements want to come to Omaha to talk, and they come up with all sorts of reasons, but what they really hope is that we become interested in their stock. That never works. The numbers tell us a lot more than the managements. We don’t give a hoot about anyone’s projections. We don’t want even want to hear about it.” (Source: Buffett FAQ)
Checklist Items: A Few Examples from Guy Spier
In the book Spier gives a few examples of different kinds of checklist items in connection to different case studies that he goes though to show the reader the reasoning behind how he derived the items in question.
To put each checklist item below in the proper context, I urge everyone to check out Spier’s book and to read each of the case studies. In this post I will just briefly quote the questions as examples of what a checklist item could look like.
The first case study called “The Man Who Lost His Cool” is about the author’s investments in different for-profit education companies. Here the reader gets two checklist items that seem to belong in the corporate management category.
CHECKLIST ITEMS
“Are any of the key members of the company’s management team going through a difficult personal experience that might radically affect their ability to act for the benefit of their shareholders?”
“Also, has this management team previously done anything self-serving that appears dumb?”
The second case study is called “A Tortuous Tale of Tupperware,” and it’s about the Tupperware Plastics Company. This investment turned out to be a failure, and a failure that failed slowly. The reason? Because “…there was too much competition, and the high price of its products had become a serious obstacle to growth.” In this case, Spier concludes that he “…failed to ask the most obvious question: does this product offer good value for money?” Spier further concludes that “This misadventure taught me an invaluable lesson: I want to invest only in companies that are a win-win for their entire ecosystem.” With ecosystem Spier refers to “the value chains.”
CHECKLIST ITEM
“Is this company providing a win-win for its entire ecosystem?”
In case study number three “What Lies Beneath?” Spier goes on to discuss his investment in CarMax―“the Wal-Mart or Cotsco of secondhand cars.” CarMax business is heavily dependent on the company being able to provide its customers with financing, since without financing customers won’t be able to buy a car. In other words, debt markets was (and is) of utmost importance for CarMax’s business model. So, what happened? The financial crisis happened, and customers were not able to obtain the credit needed to buy a car, and as a result sales dropped and the stock price dropped too.
Spier’s greatest insight from his CarMax investment was that the “…situation taught [him] how critical it is to discern whether a business is overly exposed to parts of the value chain that it can’t control.”
CHECKLIST ITEM
“How could this business be affected by changes in other parts of the value chain that lie beyond the company’s control? For example, are its revenues perilously dependent on the credit markets or the price of a particular commodity?”
The fourth, and the last, case study is “How I Lost My Balance.” This case study is about a food company called Smart Balance (since renamed Boulder Brands), and about the author’s “narcissistic hubris” that led him to pay too high a price for the business.
CHECKLIST ITEMS
“Is this stock cheap enough (not just in relative terms)?”
“Am I sure that I’m paying for the business as it is today—not for an excessively rosy expectation of where it might be in the future? Does this investment satisfy me psychologically by meeting some unmet personal need? For example, am I keen to buy it because it makes me feel smart?”
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.
[Shane Parrish] And for Charlie, and for you, you can probably just mentally go through this list. How do you feel about checklists, or how do you make sure you have thought about things from— it seems like ever since Atul Gawande’s book The Checklist Manifesto there’s been a movement not only in the value investing community, but a movement in hospitals, a movement to go back to—maybe the airlines are doing something right: maybe the low fatalities and the very methodical approach to things has an advantage. How do you make sure that you’re capturing all the mental models that you have? And bringing them to bear on a particular problem? 
Think Twice by Michael Mauboussin is a great book for everyone who wants to gain a deeper understanding and learn more about the different kinds of heuristics, i.e., mental shortcuts that allows people to solve problems and make judgments quickly and efficiently. These rule-of-thumb strategies shorten decision-making time and allow people to function without constantly stopping to think about their next course of action. Heuristics are helpful in many situations, but they can also lead to cognitive biases.
Hurricane Capital 