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Grahamites
Grahamites
Articles (221) 

Some Observations on the Checklist Approach

A few lessons learned from applying the strategy

May 10, 2017

“We need a different strategy for overcoming failure, one that builds on experience and takes advantage of the knowledge people have but somehow makes up for our inevitable human inadequacies. And there is such a strategy – though it will seem almost ridiculous in its simplicity, maybe even crazy to those of us who have spent years carefully developing ever more advanced skills and technologies.

It is a checklist.” Atul Gawande

I have to admit: I have been struggling in terms of figuring out which investment checklist I should use and the proper way to use a checklist. The purpose of the checklist is to serve as a reminder and reduced unforced errors. However, striking the right balance between “too many items” and “not enough items” has been a struggle for me.

Like many readers, I found out about the checklist concept through Charlie Munger (Trades, Portfolio), Mohnish Pabrai (Trades, Portfolio) and Micheal Shearn with his wonderful book “The Investment Checklist.” It was either late 2013 or early 2014 that I decided to implement the checklist system in my investment process.

My early attempt was to develop a comprehensive checklist so that I would not miss anything. That was idiotic. I ended up with a laughably large document with more than 200 items on it. Believe me, it was comprehensive. It covered anything you can think of. Of course that was a disaster because I’ve only gone through the whole list once and it took me a long time. It became clear that it was more like a research list than a checklist.

Then I started to trim the checklist in multiple rounds it was an exercise of subtraction. The first round of trimming was smooth. I got rid of more than half of the items. I also wanted to make sure that the checklist system was adaptive, flexible and Darwinian. But the challenge was to prioritize the checklist items in a way so that 20% of them would do 80% of the work, at the same time making sure no important items were missing from the list.

Through trial and error, I’ve found the following general ideas extremely helpful when it comes to developing a practical checklist system.

1. Buffett and Munger’s simple four-filter system should be the starting point. Most of us have underestimated the power of those filters, especially filter No. 1 (Is this a business I can understand?).

2. It is helpful to have a few general checklist items that could prevent a catastrophic event such as:

  • Has the company taken on leverage to make a big acquisition or to expand production capacity (think about Zinc)?
  • Are there any disruptive technological advancements that will make the company’s offering obsolete?
  • Is the company's success dependent on factors that are unknowable to me such as fashion taste change and short- and medium-term commodity price? Is the business in retail, energy or the precious materials sector?
  • In situations in which a business makes the majority of its profit from a disproportionately small number of customers, has anything changed that would impact the revenue per customer in that specific customer group? In other words, do I understand the most important factors affecting the revenue mix?
  • In what ways would new regulation impact the food chain in the ecosystem and who will be the winners and losers? How would the losers react and how would the losers’ reaction affect others?

3. It really helps to build your circle of competency in a sector and the industries within the sector so you can come up with sector- and industry-specific checklist items. For instance, three of my checklist items for the health care sector are:

  • Does the health care company deliver better quality of care or provide safer and better efficacy products than somebody could get anywhere else? (shamelessly taken from Weschler)
  • Does the company deliver a net savings to the health care system? (again, shamelessly taken from Weschler)
  • What is the payer mix (government vs. private) and how has it changed over time?

Then within the health care sector, I have another general checklist for molecular diagnostic companies that includes a few items such as:

  • Does the test have enough peer review and validation report? Does the test deliver better specifity and sensitivity?
  • Can the company provide economic analyses demonstrating strong potential cost saving benefits to both the payers and the patients?
  • Are the payers going to pay for the test and at what price?
  • Can the test change physician behavior?

The sector- and industry-specific checklists are a result of knowledge and experience accumulation. It’s not something you can come up with just by thinking and read value investing-related books or articles.

4. I highly recommend including Munger’s human misjudgment framework as a separate behavioral checklist. You may also develop a special lollapalooza checklist that should include common bias combinations such as say social proof plus overconfidence plus deprival super reaction.

What I have written above are a few things I have found helpful in developing my own checklist system. I know it’s far from perfect so I look forward to hearing thoughts, suggestions and criticism from the readers.

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