Sanjay Bakshi on Checklists

“Knowledge is power.” —Francis Bacon

Knowledge is Power, and Farnam Street is the Street where Warren Buffett Lives

Farnam Street’s The Knowledge Project is Shane Parrish’s podcast where he “interview[s] people from across the globe to deconstruct how they think, live, and connect ideas. The core themes will seem familiar to Farnam Street readers: Decision Making, Leadership, and Innovation.”

In the third episode of the Knowledge, Shane Parrish talks to Professor Sanjay Bakshi on reading, mental models, worldly wisdom, checklists and investing.

To listen to the interview, click here.

To read the transcript, click on the image below or here.

Transcripts are provided for all podcast interviews, and available via signing up for a membership over at Farnam Street.

Checklists: Sanjay Bakshi’s Wisdom

One of the subjects discussed by Shane and Sanjay in the interview is checklists. In his answer to Shane’s question Sanjay elaborates on how to think about checklists.

Sanjay_Bakshi_FS[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?

[Sanjay Bakshi] When you think about checklists, I think what you’re trying to do is to reduce your rate of error. And there’s a trade-off here. I think what Atul Gawande has done – he’s done a marvellous service to civilisation by giving us a framework for how to reduce error. And it doesn’t have to be domainspecific. It could be flying a plane, as he talks about in Chapter 1 in that book. It could be about running a hospital operation. It could be also be about running an investment operation.

But all of that is focussing on how to reduce error. But that’s just one aspect of it. Because reducing error is not always the most optimal thing to do. You also have to be creative. If you’re going to be creative, you’re going to make mistakes. If you look at any business which has been innovative, you’ll find that they have made mistakes. So there are two things here: you need to have the framework to create insights, which means you need to have a creative mind-set, which means that you should be willing to experiment, and sometimes make mistakes. At the same time, when you’re actually making big decisions, you also need to have a framework to reduce error. I think Atul Gawande’s work, and the movement that he has created that you are referring to, deals very well with that aspect. It doesn’t deal at all with the idea that you want to be creative. You need both. You need to have the ability to have unique insights. And you also need to have the ability to reduce your error rate.

Relevant Links

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.

Think Twice: Checklists

“Before I enumerate those actions, let’s start with what you need not do. You needn’t think twice before every decision. Since most decisions will be straightforward, with clear-cut repercussions, the mistakes in this book will not be relevant. We all make lots of decisions every day, and the stakes are generally low. Even when they are not low, the best course is often obvious enough.

Think Twice’s value comes in situations where the stakes are sufficiently high and where your natural decision-making process leads you to a suboptimal choice.

So you must learn about the potential mistakes (prepare), identify them in context (recognize), and sharpen your ultimate decisions when the time comes (apply). Here are some thoughts on what you should do differently tomorrow.”

—Michael Mauboussin, Think Twice

Mauboussin on Creating a Checklist

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.

Mauboussin wraps up by offering some very concrete actions based on the discussion in the book. The actions are: 1) Get Feedback, 2) Create a Checklist, 3) Perform a Premortem, and 4) Know What You Can’t Know.

Since the subject of checklists has been up for discussion on this blog before, I thought I’d save the part from Mauboussin’s concluding thoughts and discussion about the second action point: Create a Checklist.

Below is an excerpt from Think Twice: Harnessing the Power of Counterintuition, written by Michael Mauboussin. I encourage you all to read it. Every page is full of insights and advice that you will benefit from in your day-to-day operations and decision-making.

Create a Checklist. When you face a tough decision, you want to be able to think clearly about what you might inadvertently overlook. That’s where a decision checklist can be beneficial.

For example, in 2009 the New England Journal of Medicine published the results of a study tracking the rate of complications from surgery before and after the introduction of a checklist. The study was based on data from more than seventy-six hundred operations in eight cities around the world. The researchers found that rate of death dropped almost by half when the doctors used the checklist, and that other complications fell by one-third. [7] Pilots, of course, also find great value in checklists to ensure safety. But the question is whether you can develop a checklist for all activities.

People underutilize checklists. But a checklist’s applicability is largely a function of a domain’s stability. In stable environments, where cause and effect is pretty clear and things don’t change much, checklists are great. But in rapidly changing environments that are heavily circumstantial, creating a checklist is a lot more difficult. In those environments, checklists can help with certain aspects of the decision. For instance, an investor evaluating a stock may use a checklist to make sure that she builds her financial model properly.

A good checklist balances two opposing objectives. It should be general enough to allow for varying conditions, yet specific enough to guide action. Finding this balance means a checklist should not be too long; ideally, you should be able to fit it on one or two pages.

If you have yet to create a checklist, try it and see which issues surface. Concentrate on steps or procedures, and ask where decisions have gone off track before. And recognize that errors are often the result of neglecting a step, not from executing the other steps poorly.

[7] Atul A. Gawande, MD, et al., “A Surgical Checklist to Reduce Morbidity and Mortality in a Global Population,” New England Journal of medicine 360, no. 5 (20009): 491-499. See also Peter Bevelin, Seeking Wisdom: From Darwin to Munger, 3rd ed. (Malmö. Sweden: Post Scriptum AB, 2007), 287-296.

Checklists come with pros and cons. Handle with care, and hopefully, your checklist will help you in your attempt to make smarter and more insightful decisions.

See here for earlier blog posts in the category: Checklists. Here you’ll find more to read about Atul Gawande, among other things.

Further Reading: Mauboussin

Check out the official homepage of Michael Mauboussin here. Below are a list of other great books from Mauboussin worth reading.

Further Reading: Atul Gawande

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.

Checklist for Evaluating Generals

“We’re generally overconfident in our opinions and our impressions and judgments.”

—Daniel Kahneman

Different Weather Requires Different Clothing…

In his Partnership Letters Warren Buffett discusses four different investment methods used by him in order to best act in accordance with his investment principles. The methods are: (1) Generals-Private Owner, (2) Generals-Relatively Undervalued, (3) Workouts, and (4) Controls.

In Buffett’s Ground Rules, written by Jeremy Miller, the author provides the following checklist as a tool for evaluating a potential investment in a General, i.e., both Generals-Private Owner and Generals-Relatively Undervalued.

Here is a checklist for evaluating a potential investment in a General: (1) Orient: What tools or special knowledge is required to understand the situation? Do I have them? (2) Analyze: What are the economics inherent to the business and the industry? How do they relate to my long-term expectations for earnings and cash flows? (3) Invert: What are the likely ways I’ll be wrong? If I’m wrong, how much can I lose? (4) What is the current intrinsic value of the business? How fast is it growing or shrinking? And finally, (5) Compare: does the discount to intrinsic value, properly weighted for both the downside risk and upside reward, compare favorably to all the other options available to me? 

I enjoy reading Buffett’s Ground Rules, and one third into it I can highly recommend it. In this book the author provides a compilation of the old Buffett Partnership letters, and discusses different investment principles, methods, and digs into some of the investments made by Buffett during the 1956-1969 era.

The author then goes on to provide some insight about what to do when you’re not able to clear each paragraph in the checklist.

If you find yourself unable to make it all the way through the checklist, then write down in a single paragraph the metrics of the investment. If you get caught up along the way, either do more work or simply forget the idea as “too hard” and move on to something else.

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Email Wisdom Checklist from Google

“I leave out the parts that people skip.” —Elmore Leonard

I have just finished reading How Google Works, written by Eric Schmidt and Jonathan Rosenberg with Alan Eagle. I might come back to this book in another blog post to talk more about the great ideas contained in it. But for now I’ll settle with sharing a few things about how to best handle email, or simply, some email wisdom (bolding and underlinings added by me).

Email wisdom

Communication in the Internet Century usually means using email, and email, despite being remarkably useful and powerful, often inspires momentous dread in otherwise optimistic, happy humans. Here are our personal rules for mitigating that sense of foreboding:

1. Respond quickly. There are people who can be relied upon to respond promptly to emails, and those who can’t. Strive to be one of the former. Most of the best—and busiest—people we know act quickly on their emails, not just to us or to a select few senders, but to everyone. Being responsive sets up a positive communications feedback loop whereby your team and colleagues will be more likely to include you in important discussions and decisions, and being responsive to everyone reinforces the flat, meritocratic, culture you are trying to establish. These responses can be quite short—”got it” is a favorite of ours. And when you are confident in your ability to respond quickly, you can tell people exactly what a non-response means. In our case it’s usually “got it and proceed.” Which is better than what a non-response means from most people: “I’m overwhelmed and don’t know when I’ll get to your note, so if you needed my feedback you’ll just have to wait in limbo a while longer. Plus I don’t like you.”

2. When writing an email, every word matters, and useless prose doesn’t. Be crisp in your delivery. If you are describing a problem, define it clearly. Doing this well requires more time, not less. You have to write a draft then go through it and eliminate any words that aren’t necessary. Think about the late novelist Elmore Leonard’s response to a question about his success as a writer: “I leave out the parts that people skip.” Most emails are full of stuff that people can skip.

3. Clean out your inbox constantly. How much time do you spend looking at your inbox, just trying to decide which email to answer next? How much time do you spend opening and reading emails that you have already read? Any time you spend thinking about which items in your inbox you should attack next is a waste of time. Some with any time you spend rereading a message that you have already read (and failed to act upon).

When you open a new message, you have a few options: Read enough of it to realize that you don’t need to read it, read it and act right away, read it and act later, or read it later (worth reading but not urgent and too long to read at the moment). Choose among these options right away, with a strong bias toward the first two. Remember the old OHIO acronym: Only Hold It Once. If you read the note and know what needs doing, do it right away. Otherwise you are dooming yourself to rereading it, which is 100 percent wasted time.

If you do this well, then your inbox becomes a to-do list of only the complex issues, things that require deeper thought (label these emails “take action,” or in Gmail mark them as starred), with a few “to read” items that you can take care of later.

To make sure that the bloat doesn’t simply transfer from your inbox to your “take action” folder, you must clean out the action items every day. This is a good evening activity. Zero items is the goal, but anything less than five is reasonable. Otherwise you will waste time later trying to figure out which of the long lust of things to look at.

4. Handle email in LIFO order (Last In First Out). Sometimes the older stuff gets taken care of by someone else.

5. Remember, you’re a router. When you get a note with useful information, consider who else would find it useful. At the end of the day, make a mental pass through the mail you received and as yourself, “What should I have forwarded but didn’t?

6. When you use the bcc (blind copy) feature, ask yourself why. The answer is almost always that you are trying to hide something, which is counterproductive and potentially knavish in a transparent culture. When that is your answer, copy the person openly or don’t copy them at all.

The only time we recommend using the bcc feature is when removing someone from an email thread. When you “reply all” to a lengthy series of emails, move the people who are no longer relevant to the thread to the bcc field, and state in the text of the note that you are doing this. They will be relieved to have one less irrelevant note cluttering up their inbox.

7. Don’t yell. If you need to yell, do it in person. It is FAR TOO EASY to do it electronically.

8. Make it easy to follow up on requests. When you send a note to someone with an action item that you want to track, copy yourself, then label the note “follow up.” That makes it easy to find and follow up on the things that haven’t been done; just resend the original note with a new intro asking “Is this done?

9. Help your future self search for stuff. If you get something you think you may want to recall later, forward it to yourself along with a few keywords that describe its content. Think to yourself, How will I search for this later? Then, when you search for it later, you’ll probably use those same search terms.

This isn’t just handy for emails, but important documents too. Jonathan scans his family’s passports, licenses, and health insurance cards and emails them to himself along with descriptive keywords. Should any of those things go missing during a trip, the copies are easy to retrieve from any browser.

Heroes in the Age of Checklists

“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.

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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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Click here to read more about The Checklist Manifesto over at Amazon.com.

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.

Industry Checklists: Building a Library of Questions—Health Care

“You need a different checklist and different mental models for different companies. I can never make it easy by saying. ‘Here are three things’. You have to derive it yourself to ingrain it in your head for the rest of your life.” —Charlie Munger

Industry Analysis and the Search for Moats

In The Five Rules for Successful Investing, Pat Dorsey devotes chapter 13—A Guided Tour of the Market—to an industry review and focuses “on the tools for understanding different areas of the market.” Dorsey begins with a discussion of economic moats in different industries, and writes that:

…it’s easier for companies to make money in some industries than in others. Moreover, some industries lend themselves to the creation of economic moats more so than others, and these are the industries where you’ll want to spend most of your time. Although we don’t advocate a top-down investment strategy—in which you select areas of the market that you think will perform better than others and invest heavily in your top-rated industries—the economics of some industries are superior to others. Hence, you should spend more time learning about attractive industries than unattractive ones.

As a business analyst and investor it’s important to continuously improve ones knowledge of different industries, this to be able to focus on the most important metrics for a certain business, and be able to cut out any noise and try to get down to the few things that matter the most and that you need to understand to be able to know the fundaments of a certain business. Regarding differences in industry characteristics, Dorsey writes:

Every industry has its own unique dynamics and set of jargon—and some industries (such as financial services) even have financial statements that look very different […]. I asked Morningstar’s staff of 30 equity analysts to put together a series of chapters covering just about every corner of the market. These chapters should help you wade through the different economics of each industry and understand how companies in each industry can create economic moats—which strategies work and how you can identify companies pursuing those strategies.

Health Care

Before discussing the different industries, Dorsey briefly gives a few hints as to what areas of the market that are worth more of your time. One of these areas is health care, of which Dorsey writes:

This area of the market is similar to financial services because the long-term demand outlook is very strong, and companies tend to be highly profitable. […] even smaller firms can build lasting economic moats. Tread carefully with biotechs and some managed-care firms. Most biotechs are single-product lottery tickets, and most managed-care firms are affected by truly arcane regulatory issues—seemingly minor changes in Medicare rules can have a huge impact.

The other areas that Dorsey suggests is worth more of your time is; Banks and Financial Services, Business Services, and Media.

Health care “is one of the few areas of the economy that’s directly linked to human survival,” and another benefit according to Dorsey, is that “Health care firms benefit from consistent demand, as well. Even when the economy is in the tank, people still get sick and need doctors and hospitals. As a result, the health care sector has traditionally been a defensive safe heaven.”

About the attractiveness of the health care industry, Dorsey concludes, that many “areas in the health care sector are dominated by a few big players that don’t need to compete on price. As a result, health care companies are often highly profitable, with strong free cash flow and returns on capital.”

The different sub-sectors in the health care industry “includes drug companies, biotechs, medical device firms, and health care service organizations. Of all these areas, we think drug companies and medical devices firms are usually the most promising because they typically have the widest moats. However, investors often get swept away by these companies’ heady growth rates, so valuations can be steep.”

Moatiness in Health Care

What kinds of economic moats are we supposed to be expecting when looking the health care industry?

According to Dorsey, health care companies “often benefit from economic moats in the form of high start-up costs, patent protection, significant product differentiation, and economies of scale.”  This makes it “tough for new players to enter the market, particularly for drug companies with valuable patent rights, managed care organizations with large provider networks, or medical device firms with long clinical track records. These characteristics make for great profitability: The market-weighted return on equity for health care firms has averages 23 percent over the last five years, despite the economic recession.”

Pharmaceutical companies with patent protection protecting direct competition, give a firm pricing power to charge the highest price the market will bear for prescription drugs. Most costs “are paid by insurance plans,” which results in “even less price sensitivity for the end consumer.” The ability to raise prices that’s made possible from the pricing power at hand, combined with economies of scale leads to “gross margins often surpassing 75 percent to 85 percent.”

Barriers to entry is important, maybe the most important thing to understand when talking about strategic logic, and size is “another barrier to entry for drug companies.” It “can take 15 to 20 years to get through the entire research and development, and regulatory process and can cost hundreds of millions over that time frame.” Even if a potential entrant have access to the capital required to enter the health care industry, Dorsey writes that “even if they surmount the time and money hurdles, going head-to-head agains a Pfizer of Merck when selling to physicians requires a large salesforce and lots of advertising dollars. In contrast to, say, software or restaurants, where start-up costs are low and new entrants spring up frequently, consolidation has been the trend for many health industries in the last several decades, and established players usually have an edge. Smaller firms often can’t compete.”

So, is an investment in the health care industry a no-brainer? Probably not, and Dorsey explains that the health care sector is also “fraught with complex relationships, intense controversy, and political pressures to regulate who gets what and who pays for it. Unlike clothing, computers, or consulting services, health care consumers are frequently not the one writing the check for the products and services they use, and many times they aren’t even the ones making the buy decision.”

When it comes to pricing, the industry characteristics look a bit different compared to some other industries. As an example, Dorsey explains that whereas “Wal-Mart shoppers can easily see which brand of paper towels is cheapest and works best on big spills, pricing is often opaque to health care consumers and irrelevant to physicians helping to make the decisions. Thus there is little incentive to shop around for the best price to keep costs lower. (This trend has shown some signs of changing, as companies have been shifting a greater percentage of the health care burden to their employees. But overall, price generally isn’t the primary consideration for a patient seeking medical care or a doctor prescribing a drug.)”

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(Image Source: Why Moats Matter, The Morningstar Stock Approach to Investing)

Different Checklists for Different Companies

Charlie Munger has said that you “need a different checklist and different mental models for different companies,” and that you “have to derive it yourself to ingrain it in your head for the rest of your life.”

Dorsey finishes the section about health care with a checklist questions to remember and consider when analyzing the health care industry, and businesses in it.

Investor’s Checklist: Health Care

• Developing drugs is time-consuming, costly, and there are no guarantees of success. Look for companies with long patent lives and full pipelines to spread the development risk.
• Drug companies whose products target large patient populations or significant unmet needs have a better chance of paying off.
• Make sure you have a big margin of safety for pharmaceutical companies with megablockbuster drugs that make up a large percentage of sales. Any unexpected developments can send cash flow, and the stock price, reeling.
• Unless you have a deep understanding of the technology, don’t invest in biotech startups. Payoffs could be large, but the cash flows are so far out and uncertain that it’s easier to lose your shirt than win big.
• Don’t overlook the medical device industry, which is full of firms with wide economic moats.
• Cash is king for firms that rely on development (pharmaceuticals, biotechnology, and medical devices). Make sure firms have enough cash or cash from operations to get through the next development cycle.
• Keep an eye on the government. Any drastic changes in Medicare/Medicaid spending or regulatory requirements can have a deep impact on pricing throughout the sector.
• Managed care organizations that spread risk—whether through a high mix of fee-based business, product diversification, strong underwriting, or minimal government accounts—will provide more sustainable returns.

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New Mauboussin Paper: Total Addressable Market (incl. Checklist)

Title: Total Addressable Market – Methods to Estimate a Company’s Potential Sales
Authors: Michael J. Mauboussin & Dan Callahan, CFA
Date: September 1, 2015

“TAM is an area where overconfidence and optimism are rife. We have provided some analytical approaches to check these biases and to come up with a reasonable assessment of whether the market’s expectations are reasonable.” —Mauboussin & Callahan, Total Addressable Market – Methods to Estimate a Company’s Potential Sales

The concept of total addressable market (TTM) is the subject of Mauboussin and Callahan’s most recent paper.

“The ability to calibrate the total addressable market (TAM) is a major part of anticipating value creation. Since 1960, about one-third of the value of the S&P 500 Index has been attributable to the anticipated payoff from future investment. Assessing value creation requires understanding how much a company can invest and the returns those investments will earn.

We define TAM as the revenue a company would realize if it had 100 percent share of a market it could serve while creating shareholder value. TAM is a concept that executives and investors use frequently, but that few define properly or thoughtfully. You should recognize up front that TAM is not about how large a firm can grow to be but rather how much it can expand while adding value”

Click on the image below to read the paper.

MM1

Included in this paper is an checklist addressing certain important questions to consider when performing an analysis of TAM.

Checklist for Estimating a Total Addressable Market

Categorizing New Products

  • Is the product technology new or current?
  • Are the customers new or current?

Market Size

  • Are the users and payers of the good or service the same?
  • How much money do the buyers have?
  • Are the resources of buyers growing or shrinking?
  • Are there physical limitations, such as how much one can eat or use a product, that can curb demand?
  • What is the elasticity of demand?
  • How cyclical is demand?
  • How do consumers allocate their time and money now and how might that change?
  • Are the suppliers and sellers of the good or service the same?
  • What is the business’s production capacity?
  • Is there a reliable infrastructure to get the goods or services to market?
  • How broad is the geographical footprint?
  • Where is the industry in its life cycle?
  • What does that imply about the growth rate and pricing flexibility?
  • Does manufacturing capacity match the rate of growth in demand?
  • Is the company using pricing as a lever to drive scale or to increase profitability?
  • Are there existing or potential economic or social regulations that could limit TAM?
  • What are management’s incentives and are they aligned with shareholders?
  • Are there economies of scale? Local? National? International?
  • Are there two or more competitors, which could push each company into a separate niche?

TAM and the Bass Model

  • Which stage of the life cycle is the company’s industry in?
  • What analogous products can inform your estimates for the Bass Model parameters?
  • Limitations of the Bass Model When a consumer buys something once, how frequently does he or she replace it (repurchase rate)?
  • Has the company’s good or service overshot the market?
  • Might that happen soon?
  • Does the company have a competitive advantage that will allow for value creation over time?
  • Do network effects exist?
  • Consider Base Rates What happened to other companies when they were in a situation similar to the one you are examining?
  • Are your TAM estimates plausible when considering these base rates?

TAM and Ecosystems

  • Does the company operate primarily a physical, service, or knowledge business?
  • What is the company’s source of advantage?
  • What are the investment triggers?
  • Does the company sell rival or nonrival goods?
  • Are there opportunities to extend into new business categories?

Want More?

See here for a collection of links to other Mauboussin papers.

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.