The best way to replicate an investment process is to make use of a checklist.
Using a checklist accomplishes several goals. For a start, it streamlines the whole process. If you have a checklist of red flags to consider before investing, you can quickly run through which criteria the asset meets and which it does not.
A checklist also helps jog your memory. The human mind is a pretty incredible thing, but remembering 100 or so different points every time you analyze an investment is going to be difficult for even the most intelligent investors. By using a checklist, you don't have to worry about trying to remember all of these criteria. The checklist has them all for you.
What's more, you don't need to worry about remembering any additional criteria that need to be added. You can tack them on the end of the checklist. Thus, even a small checklist can help streamline and refine the investment process.
Buffett on checklist investing
Warren Buffett (Trades, Portfolio) spoke about the checklist he uses to analyze investments at the 1998 Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) annual meeting.
Responding to a shareholder who asked for his thoughts on the checklist process, Buffett layed out the steps he uses to asses the potential investments for the Berkshire portfolio:
"The criteria for selecting a stock is really the criteria for looking at a business. We are looking for a business we can understand. That means they sell a product that we think we understand, or we understand the nature of the competition, what could go wrong with it over time. And then when we find that business we try to figure out whether the economics of it means the earning power over the next five, or 10, or 15 years is likely to be good and getting better or poor and getting worse. But we try to evaluate that future stream. And then we try to decide whether we're getting in with some people that we feel comfortable being in with. And then we try to decide what's an appropriate price for what we've seen up to that point."
As the Oracle of Omaha went on to explain, this checklist is not very complicated or expensive, but it does the job quite well.
Simple is best
At its core, the checklist is designed to help Buffett stay away from investments that he doesn't understand and that look expensive. The list does not have to be particularly extensive for an investor to meet this goal.
After laying out the simple points above, Buffett handed the microphone over to his right-hand man at Berkshire, Charlie Munger (Trades, Portfolio), who gave his thoughts on making investment decisions:
"Yeah. If finance were — when finance is properly taught, it should be taught from cases where the investment decision is easy. And the one I always cite is the early history of National Cash Register Company, and that was created by a fanatic who bought all the patents, and had the best salesforce, and the best production plants. He was a very intelligent man and passionately dedicated to the cash register business. And of course, the cash register business was a godsend to retailing when cash registers were invented...If you read an early annual report prepared by Patterson, who was CEO of National Cash Register, an idiot could see that this was a talented fanatic. Very favorably located, and that, therefore, the investment decision was easy."
Buffett and Munger believe that the best way to achieve investment success over the long term is to keep things simple, invest in what you know and stay away from complex situations.
Buffett's simple checklist meets this aim. Many investors could improve their circumstances by adopting a similar approach. Sometimes, the most straightforward methods are the most effective. Buffett's investment track record stands testament to that.
Disclosure: The author owns shares in Berkshire Hathaway.
Read more here:
- Seth Klarman on 'Value Pretenders'
- Seth Klarman and George Soros: Reflexivity and Stock Prices
- Seth Klarman: The Importance of Liquidity
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