Is investing an art or science? It depends on who you ask. Some investors swear by a scientific approach, Renaissance Technologies for example, which has managed to beat the market for years with computer algorithms.
On the other hand, you have famous investors such as Warren Buffett (Trades, Portfolio), who have made their fortunes with their investment skill, a skill that is almost impossible to replicate or everyone else would be achieving Buffett-like returns.
The average investor does not have the firepower, experience, time or network of connections that Warren Buffett (Trades, Portfolio) has, nor do they have the know-how to construct a computer-driven scientific trading program. Whatâs more, you do not need to look far to find evidence showing the average investor does nit have what it takes to beat or even match the wider market. According to a study conducted by financial research firm DALBAR, the average investor realized an average annual return of only 3.7% a year over the past three decades, underperforming the wider market by around 5.3% annually.
Simply put, the odds are stacked against the average investor, but there is a way to help investors like you and me improve their investment strategy without having decades of experience or a multi-million dollar computer program behind us.
Introducing the Checklist
The investment checklist has to be one of the most underused investment tools there is.
The checklist has many advantages. It can streamline your investment process, remind you of particular facts to consider when looking at an investment and a checklist can help you avoid the riskiest investment opportunities.
Checklists do not guarantee perfect performance, but they certainly help you improve your performance. From my personal experience, by using a checklist that I have constructed over the years by dissecting all of my trades, I have been able to avoid catching a number of falling knives this year.
One of the biggest risks value investors face is falling into value traps and lists can be invaluable in helping you navigate around these traps.
For example, I have discovered over the years that negative free cash flow companies tend to be extremely poor performers, so now I will only buy stocks with a positive free cash flow.
Further, I want to be investing alongside management, so one of my checklist points is âmanagement skin in the gameâ, I am even more interested if management has been buying recently in large quantities. These are just two of the 40 or so points on my checklist, which covers everything from management experience to the competitive environment and balance sheet strength. So far this checklist has helped me avoid many serious disasters.
Why Are You Not Using a Checklist?
As the The Value Investing Blog of Old School Value notes, most investors avoid using checklists as they take time to create. But like everything that is worth having in life, checklists take time to create for a reason, they can literally help you save thousands or tens of thousands of dollars over time.
Another huge positive about checklists is they remove the element of human emotion and error from investing. Anyone who has read "The Little Book of Behavioral Investing" by James Montier will understand how disastrous human emotion can be to investment returns over time. In fact, if you type âBehavioral Investingâ into a search engine right now, I am sure you will be bombarded with information telling you how your own emotions are one of the most significant factors holding back your returns.
The most famous investment checklist is probably Benjamin Grahamâs "Last Will and Testament," the checklist of ten rules for selecting stocks published just before Grahamâs death.
Checklist of Ben Grahamâs 10 Rules for Selecting Stocks:
1. Does the stock have an earnings yield of 2X that of AAA Bonds?
2. Does the stock have a P/E of no larger than 4/10 of the highest average P/E during the last 5 years?
3. Does the stock have a dividend yield of 2/3 of the AAA bond yield?
4. Is the stock trading at 2/3 of tangible book value?
5. Is the stock trading at a discount of at least 2/3 of NCAV?
6. Is Debt < Tangible Book Value?
7. Is the current ratio > 2 ?
8. Is debt ? 2X liquidation value?
9. Is earnings growth rate compounding at greater than 7% per year?
10. Have earnings been growing steadily over the last 10 years?
This is hardly the most comprehensive list, but it is perhaps the most well-know within the value investing community.
Other well-known investors have since published versions of their own checklists that are much more detailed than Grahamâs ten rules.
Charlie Munger (Trades, Portfolio) detailed a ten-point investing principles checklist in his book, "Charlieâs Almanack." Mungerâs list is more to do with principles that should be considered as part of the investment analysis process.
1. Measure risk: All investment evaluations should begin by measuring risk, especially reputational.
2. Be independent: Only in fairy tales are emperors told they are naked. [Just because other people agree or disagree with you does not make you right or wrong.]
3. Prepare ahead: The only way to win is to work, work, work, and hope to have a few insights.
4. Have intellectual humility: Acknowledging what you do not know is the dawning of wisdom.
5. Analyze rigorously: Use effective checklists to minimize errors and omissions.
6. Allocate assets wisely: Proper allocation of capital is an investorâs number one job.
7. Have patience: Resist the natural human bias to act. âCompound interest is the eighth wonder of the worldâ (Einstein)
8. Be decisive: When proper circumstances present themselves, act with decisiveness and conviction.
9. Be ready for change: Accept unremovable complexity.
10. Stay focused: Keep it simple and remember what you set out to do.
In an interview with ForbesĂ Ă inĂ 2013, Mohnish Pabrai (Trades, Portfolio) discussed how he used a checklist to minimize his mistakes in investing. And as shown below, renowned value investor Walter Schloss used a 13 point checklist to narrow down his investment choices.
These are not the only examples of investment checklists out there. If you are looking for more checklist examples and ideas to help compile your own, csinvesting has put together a Word document which complies a vast array of checklists from investors following many different styles. Itâs well worth a read.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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