The investment checklist is, in my opinion, one of the most overlooked tools an investor can use to improve their outcome.
By using a checklist, you can standardize your investment process, ensuring you don't repeat the same mistakes time and again, by building a list based on what you've learned throughout your career.
Mohnish Pabrai (Trades, Portfolio), the leader of Pabrai Investment Funds and one of the best value investors of all time, is a vocal proponent of the investment checklist.
Several years ago, he gave a presentation at Columbia Business School outlining why investors should use a checklist in their day-to-day investment activities and provided some real-world examples.
Checklist tips
The presentation began with a short history of the checklist, outlining some of the most famous situations where lists have dramatically improved the outcomes for all involved.
For example, the ICU Line Insertion checklist, which, when introduced, reduced the percentage of people who contracted an infection after having a line inserted while in the intensive care unit from 4% (approximately 80,000 people a year with a 5% to 28% fatality rate) to 0%.
The presentation goes on to say that the reason why checklists are so important is they prevent us from being fooled by our brains.
Pabrai noted that "our brains are designed to take shortcuts and arrive at answers quickly," which inhibits our ability as investors to analyze a security. "When we notice a great business is undervalued, we read up on it, run through a number of concerns/questions and arrive at a decision –not as effective as a checklist," he said.
Building a checklist does not require a vast amount of work. You need to be able to recognize what mistakes you have made in the past, as well as the mistakes of others, that contributed to losses. In his presentation, for example, Pabrai discussed Cort Furniture, which Charlie Munger (Trades, Portfolio) bought for Wesco in 2000.
Over the next several years, this turned out to be a poor investment for Wesco. The company grew but never really generated substantial returns for the holding company, and profitability was mixed.
Cort was (and still is) an office furniture rental business. When Munger swooped in on the company in 2000, it was riding high on the dot-com bubble as demand for office furniture spiked thanks to the boom in the number of startups. At the time, Pabrai noted, Munger compared the business to Enterprise Rent-a-Car, which was "a fantastic company/culture/business."
The mistake Munger made was he failed to recognize the company was experiencing abnormally high demand due to tailwinds from the favorable economic conditions. The company had unusually high revenues and free cash flow as a result of the internet bubble. Interestingly, we know both Munger and Warren Buffett (Trades, Portfolio) could see the bubble was just that, yet Munger went ahead with the deal anyway.
Looking back at this case study, Pabrai recommends two checklist points:
- Are the revenues and cash flows of the business sustainable or overstated/ understated due to boom or bust conditions?
- Are there temporary tailwinds in enhancing free cash flow?
This isn't the only case study Pabrai looks at in the presentation. He also considers Buffett's initial Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) investment, which the "Oracle of Omaha" has admitted himself is possibly the biggest mistake he's ever made.
Buffett's mistake was buying the company just because it was trading below net working capital, a strategy that worked in the past but didn't this time around. The reason why; Berkshire lacked a growth catalyst.
Considering this scenario, Pabrai recommends two additional checklist criteria:
- Downside protection -- a margin of safety.
- Upside earnings engine -- moat.
These four criteria are not the only points on Pabrai's checklist. He said there were more than 60 on the list at the time of the presentation. Since then, I believe the list has since grown to around 100 criteria.
It is certainly worth checking out this interesting presentation if you are thinking about putting together a checklist.
Disclosure: The author owns shares of Berkshire Hathaway.
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