If you’re trying to analyze a company without using an adequate checklist, you may make a very bad investment.
-Charles T. Munger,
Chairman, Wesco Financial Corp.
Vice Chairman, Berkshire Hathaway
Early man spent most of his time as a hunter and gatherer. For Paleolithic man (P-man), life was very tough. Prior to the development of agriculture, P-man needed to adapt to the challenges of hunting and gathering in a harsh environment. P-man had to deal with defending his small group from enemies and predators, in addition to bringing home the bacon. His brain had to adapt in order to survive, and he developed fear.
Fear helped him to anticipate danger and avoid pain. There was no absence of fear for P-man; he feared physical danger, being shunned by his clan, lack of food, etc. His brain had to create a way to process information quickly so that he could survive; one slipup and he was a goner. Take the case of two P-men out on a hunt. One of them hears some rustling behind a bush. Curious, he goes over to investigate. As he bends down to see what is making the noise, he gets bitten in the neck by a wolf and dies. Seeing what happened to his friend, the other P-man hightails it out of there. The surviving P-man learns a valuable lesson that day: Stay away from rustling bushes. He also learns that it is better to be safe than sorry, that pain (and death) can be avoided if he begins to be fearful.
P-man’s brain begins to develop shortcuts: rustling bush = death, so he therefore avoids them at all costs even if most times there is no wolf lurking in the bushes. In the end, fear is a good thing as he begins to avoid situations that can cause him harm or death. Those P-men who don’t develop this emotion will never have a chance to pass on their genes to future generations because they end up dead. As time goes on, P-man learns that the more uncertain a situation is, the stronger the fear and he begins to develop shortcuts to avoid those situations.
Science has demonstrated that shortcuts are the most efficient form of behavior for humans, and in many cases, it is simply necessary. We live in a very complicated and fast-paced world. No one can be expected to analyze and categorize huge amounts of information and make a logical, well thought-out decision. There isn’t enough time in the day nor does one have that kind of brain power to do so. We begin to develop shortcuts to help us get through the day and make decisions at a quicker pace than if we had to think things through. That is why our minds are constantly searching for patterns and connections to make life and decision making more bearable.
Expensive Is Good
When I first married my wife, I couldn’t help but notice the spending behavior of my father-in-law. He wouldn’t hesitate to spend top dollar to buy the best. Sensing my aversion to spending money and always looking for a bargain, he told me that in life you will often find that, “What is cheap is expensive and what is expensive is cheap.” It took me many years to understand the wisdom of his advice. For example, in 1991, I took his advice and paid close to $300 for a pair of Allen-Edmonds shoes, which I considered an exorbitant amount of money considering the average price for men’s dress shoes was well under $100. In spite of the high cost, they turned out to be a wise investment. Not only were they the most comfortable shoes I have ever owned, they lasted a very long time – I wore them for close to 16 years! I have learned that in the long run, paying for quality has been the cheapest way to go.
I have developed, like many people, a shortcut in my decision making process: expensive = good and cheap = bad. The thinking goes that if an item is expensive then it must be expensive because of its quality and durability. An item that is cheap has to be junk because if it wasn’t, then it would be selling for a higher price. Many people also use shortcuts when listening to the advice of experts. The shortcut is: If an expert says so, then it must be true. That is why you see testimonials and endorsements for so many products and why athletes are paid millions of dollars to put their names on sneakers and clothing.
Pitfalls in Shortcuts
While we need shortcuts to get through the day, they do have their limitations. Unfortunately, shortcuts don’t always work, especially when it comes to investing. Using too many shortcuts when it comes to investing often results in a loss of capital. Investing is one area where thorough analysis should be employed and not shunned.
The current subprime meltdown is a good example on the dangers of shortcut thinking. Over the past several years, financial institutions and sophisticated investors bought collateralized mortgage obligations (CMOs), which offered higher rates than plain vanilla U.S. Treasury bills. Not having the brainpower or time to analyze the hundreds and many times thousands of mortgages that made up the CMO, investors needed a shortcut as they did their due diligence. Without one, it was highly unlikely that anyone would want to buy them. Understanding this barrier, sellers of CMOs had them rated by rating agencies. After paying them a hefty fee, the rating agency sifted through the mountains of data and then came up with a rating on the CMO. Since these ratings were universally accepted in the financial world, a shortcut was in place so that buyers would have confidence in their purchases and knew the risks they were getting themselves into. A top rating such as AAA informed the investor that the security was top quality; a lower rating such as BBB told the investor that there was a higher level of risk.
With this shortcut in place, financial institutions such as Citibank and Merrill Lynch sold tens of billions of dollars of CMOs. The problem developed when the ratings placed on the CMOs no longer meant what they previously did. In other words, the shortcut no longer worked. CMOs with AAA ratings began experiencing something that was extremely rare: defaults. It wasn’t supposed to happen but it did. Investors who bought those CMOs blamed the rating agencies as the shortcut no longer worked. The fallout from the failure of these shortcuts has caused writedowns by financial institutions that have already amounted to hundreds of billions of dollars with many more billions on the horizon.
Investors who were skeptical from the start avoided CMOs regardless of their rating. They didn’t use the ratings shortcuts to substitute for their own thinking. They simply did not buy them because they could not understand or value them. The benefits for them for avoiding this shortcut are stronger balance sheets and more profitable companies.
Another Shortcut Blows Up
A contributing factor to the subprime meltdown was another shortcut: FICO scores. Bill Fair and Earl Isaac developed a three-digit score that helped banks and department stores calculate the creditworthiness of their customers. Their company, Fair Isaac Corporation, demonstrated that the higher the FICO score, the more creditworthy the customer was. Customers with low FICO scores were considered higher risks and would have a higher probability of defaulting on their loans.
However, not every financial institution was convinced that a FICO score was an accurate measure of a person’s creditworthiness. As time went on, groups of “credit doctors” learned how to game the system and puff up low FICO scores for their clients that were being continually turned down for credit due to their low scores. Financial institutions began to rely heavily on FICO to determine the creditworthiness of customers, while at the same time the accuracy of these scores was beginning to be questioned. From the financial institutions’ point of view, it was much easier to take the FICO shortcut than do the legwork required to determine the creditworthiness of a customer.
Not every financial institution bought into this shortcut. Golden West Financial (now a subsidiary of Wachovia) was one that did not sip the FICO Kool-Aid. For several decades, Golden West operated one of the most profitable and best-managed banks in the country. The majority of their business was simple: They wrote mortgages on owner-occupied residential 1-4 family homes. Their delinquency rate prior to the housing meltdown was minuscule. Currently the industry average delinquency rate is 1.04%. Golden West’s is much lower and is running at a rate of .75%. How were they able to achieve such a substantially lower delinquency rate?
Source: Businessweek, February 18, 2008
Richard Atkinson, who oversees part of Golden West’s mortgage unit from San Antonio, says the bank calls to verify employment, examines a borrower’s stock holdings and other assets, and employs a team of appraisers who are judged not by the volume of loans but by the accuracy of the appraisal over the life of the loan. “The way we do business is a lot more costly, and cost was a big reason many competitors embraced credit scoring,” he says. “But some of our best borrowers had low FICO scores and our worst had FICO scores of 750.”
How to Avoid Shortcuts
We already agreed that without shortcuts, many of us would not be able to get through the day. Has anyone you know ever read the terms and conditions before checking the “Accept” box when installing software on their computer? Nevertheless, shortcuts can many times prove hazardous to our wealth. Charlie Munger, vice chairman of Berkshire Hathaway, offers a way to get around this problem. He said, “If you want to avoid irrationality, it helps to understand the quirks in our own mental wiring and then you can take appropriate precautions.”
Munger offers a solution by using checklists. He says, “Checklist routines avoid a lot of errors. You should have all this elementary [worldly] wisdom and then you should go through a mental checklist in order to use it. There is no other procedure in the world that will work as well.”
Warren Buffett uses a mental checklist prior to making and buying a company or stock. He asks himself:
- Does he understand the business?
- Does the company have a competitive moat?
- Is management competent?
- Is the price attractive?
Many companies do not pass through his first filter. This filtering process prevented him from investing in companies that he did not understand but were soaring to amazing heights. He avoided the whole technology and Internet bubble in the late 1990s simply because he could not get a good handle on where the industry would be in the next 10 years and didn’t understand the business.
For the stock selections in each issue of Hidden Values Alert, I too use a checklist. I start by looking for companies that are able to produce consistent and predictable earnings and revenues over a period of eight or more years, have industry-leading return on equity (ROE), manageable debt, and rising profit margins, and are selling for an attractive price. This prevents me from recommending stocks that don’t have long-term track records or dominate their industry. It would serve you well to develop your own checklists before investing so you can overcome the use of shortcuts. While shortcuts are important in other areas of your life, I highly suggest you avoid them at all costs when it comes to your investments.
This article originally appeared in the February 2008 issue of www.HiddenValuesAlert.com
Cialdini, Robert B. Influence: Science and Practice, Third Edition. HarperCollins College Publishers, New York, NY, 1993, p. 6
Foust, Dean and Pressman, Aaron, Credit Scores: Not-So-Magic Numbers.BusinessWeek, 7 Feb 2008, p. 38
Bevelin, Peter, Seeking Wisdom: From Darwin to Munger, PCA Publications LLC, 2007, p. 39