“Even the most expert among us can gain from searching out the patterns of mistakes and failures and putting a few checks in place.”—Atul Gawande, The Checklist Manifesto
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A Few Things About Checklists, Greed Mode and Cocaine Brains
Checklists. Investing. Pabrai. Spier. Gawande. Checklist Manifesto. That’s what you’ll find if you keep on reading.
Excerpt below from The Checklist Manifesto written by Atul Gawande (emphasis added).
THE HERO IN THE AGE OF CHECKLISTS
We have an opportunity before us, not just in medicine but in virtually any endeavor. Even the most expert among us can gain from searching out the patterns of mistakes and failures and putting a few checks in place. But will we do it? Are we ready to grab onto the idea? It is far from clear.
But the prospect pushes against the traditional culture of medicine, with its central belief that in situations of high risk and complexity what you want is a kind of expert audacity—the right stuff, again. Checklists and standard operating procedures feel like exactly the opposite, and that’s what rankles many people.
And it is true well beyond medicine. The opportunity is evident in many fields—and so also is the resistance. Finance offers one example. Recently, I spoke to Mohnish Pabrai, managing partner in Pabrai Investment Funds in Irvine, California. He is one of three investors I’ve recently met who have taken a page from medicine and aviation to incorporate formal checklists into their work. All three are huge investors: Pabrai runs a $500 million portfolio; Guy Spier is head of Aquamarine Capital Management in Zurich, Switzerland, a $70 million fund. The third did not want to be identified by name or to reveal the size of the fund where he is a director, but it is one of the biggest in the world and worth billions. The three consider themselves “value investors”—investors who buy shares in underrecognized, undervalued companies. They don’t time the market. They don’t buy according to some computer algorithm. They do intensive research, look for good deals, and invest for the long run. They aim to buy Coca-Cola before everyone realizes it’s going to be Coca-Cola.
Pabrai described what this involves. Over the last fifteen years, he’s made a new investment or two per quarter, and he’s found it requires in-depth investigation of ten or more prospects for each one he finally buys stock in. The ideas can bubble up from anywhere—a billboard advertisement, a newspaper article about real estate in Brazil, a mining journal he decides to pick up for some random reason. He reads broadly and looks widely. He has his eyes open for the glint of a diamond in the dirt, of a business about to boom.
He hits upon hundreds of possibilities but most drop away after cursory examination. Every week or so, though, he spots one that starts his pulse racing. It seems surefire. He can’t believe no one else has caught onto it yet. He begins to think it could make him tens of millions of dollars if he plays it right, no, this time maybe hundreds of millions.
“You go into greed mode,” he said. Guy Spier called it “cocaine brain.” Neuroscientists have found that the prospect of making money stimulates the same primitive reward circuits in the brain that cocaine does. And that, Pabrai said, is when serious investors like himself 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 team’s track record, weigh its competitors, consider the future of the market it is in— trying to gauge both the magnitude of opportunity and the margin of safety.
“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 potential investments. So that’s more or less what Pabrai did from his fund’s inception. He was disciplined. He made sure to take his time when studying a company. The process could require weeks. And he did very well following this method—but not always, he found. He also made mistakes, some of them 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. Risk is unavoidable in Pabrai’s line of work. No, these were mistakes in the sense that he had miscalculated the risks involved, made errors of analysis. For example, looking back, he noticed that he had repeatedly erred in determining how “leveraged” companies were—how much cash was really theirs, how much was borrowed, and how risky those debts 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. … Yet no matter how objective he tried to be about a potentially exciting investment, he said, he found his brain working against him, latching onto evidence that confirmed his initial hunch and dismissing the signs of a downside. It’s what the brain does.
“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,” he said. You see people around you losing their bespoke shirts, and you overestimate the dangers.
He also found he made mistakes in handling complexity. A good decision requires looking at so many different features of companies 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.” He needed an approach that could work for someone with an ordinary IQ. So he devised a written checklist.
Apparently, Buffett himself could have used one. Pabrai noticed that even he made certain repeated mistakes. “That’s when I knew he wasn’t really using a checklist,” Pabrai said.
So Pabrai made a list of mistakes he’d seen—ones Buffett and other investors had made as well as his own. It soon contained dozens of different mistakes, he said. Then, to help him guard against them, he devised a matching list of checks—about seventy in all. One, for example, came from a Berkshire Hathaway mistake he’d studied involving the company’s purchase in early 2000 of Cort Furniture, a Virginia-based rental furniture business. Over the previous ten years, Cort’s business and profits had climbed impressively. Charles Munger, Buffett’s longtime investment partner, believed Cort was riding a fundamental shift in the American economy. The business environment had become more and more volatile and companies therefore needed to grow and shrink more rapidly than ever before. As a result, they were increasingly apt to lease office space rather than buy it—and, Munger noticed, to lease the furniture, too. Cort was in a perfect position to benefit. Everything else about the company was measuring up—it had solid financials, great management, and so on. So Munger bought. But buying was an error. He had missed the fact that the three previous years of earnings had been driven entirely by the dot-com boom of the late nineties. Cort was leasing furniture to hundreds of start-up companies that suddenly stopped paying their bills and evaporated when the boom collapsed.
“Munger and Buffett saw the dot-com bubble a mile away,” Pabrai said. “These guys were completely clear.” But they missed how dependent Cort was on it. Munger later called his purchase “a macroeconomic mistake.”
“Cort’s earning power basically went from substantial to zero for a while,” he confessed to his shareholders.
So Pabrai added the following checkpoint to his list: when analyzing a company, stop and confirm that you’ve asked yourself whether the revenues might be overstated or understated due to boom or bust conditions.
Pabrai and Spier, the Zurich investor, found the same phenomenon. Spier used to employ an investment analyst. But “I didn’t need him anymore,” he said. Pabrai had been working with a checklist for about a year. His fund was up more than 100 percent since then. This could not possibly be attributed to just the checklist. With the checklist in place, however, he observed that he could move through investment decisions far faster and more methodically. As the markets plunged through late 2008 and stockholders dumped shares in panic, there were numerous deals to be had. And in a single quarter he was able to investigate more than a hundred companies and add ten to his fund’s portfolios. Without the checklist, Pabrai said, he could not have gotten through a fraction of the analytic work or have had the confidence to rely on it. A year later, his investments were up more than 160 percent on average. He’d made no mistakes at all.
What makes these investors’ experiences striking to me is not merely their evidence that checklists might work as well in finance as they do in medicine. It’s that here, too, they have found takers slow to come. 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, whatever—gets sucked up by the giant maw almost instantly. Every idea, that is, except one: checklists.
We don’t like checklists. They can be painstaking. They’re not much fun. But I don’t think the issue here is mere laziness. There’s something deeper, more visceral going on when people walk away not only from saving lives but from making money. It somehow feels beneath us to use a checklist, an embarrassment. It runs counter to deeply held beliefs about how the truly great among us—those we aspire to be—handle situations of high stakes and complexity. The truly great are daring. They improvise. They do not have protocols and checklists.
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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.