This is my current investment checklist. The idea of an investment checklist came from Mohnish Pabrai, and I believe his motivation to create an investment checklist came from the book The Checklist Manifesto by Atul Gawande.
I use this investment checklist every time I consider buying a new stock or more of a current stock. And this checklist is never completed. I’ll likely add to it from time to time.
First, Focus On The Downside
As I wrote about here, I need to always focus on the downside first. What is the downside? Is there a downside? How can I lose money? I want situations where I can’t lose money.
Warren Buffett’s Two Rules
I’m not kidding about focusing on the downside. Follow Warren Buffett’s two rules: rule number one, don’t lose money. Rule number two, don’t forget rule number one. Seriously, how can I lose money on this investment idea? Take a few minutes and think about downside scenarios, how I could lose money on this investment, and how likely those scenarios are. Don’t forget, sometimes I won’t be able to handicap the likelihood, and that’s okay. If that’s the case, stop here and throw it in the too hard pile and move on.
Is this a growing pie?
I only want growing pies. I don’t want fixed pies. If I’m investing in a cigar butt, a fixed pie (or worse, a shrinking pie), why? How big is the potential payoff? The payoffs I want, the 5, 10, 50, and 100 baggers, they don’t come from fixed pies, they only come from growing pies. If this is not a growing pie, I better have a large payoff that comes with very low risk, do I?
Pouring Out Champagne To Drink Piss
What am I selling to free up funds to buy this new stock? It is too easy to sell what looks like a fully-valued great business run by a great manager or even a wonderful business that can be run by an idiot in order to free up money to invest in a very cheaply-priced bad or normal business. In fact, it often feels right. But this is a very dumb thing to do. Do not sell a wonderful business or a great business run by a great manager in order to buy a bad or normal business that’s cheap. Just say no!
Unless it is just egregiously overvalued, never sell a wonderful business and never sell a great business run by a great manager. They are simply too powerful and too rare to get your hands on at a good price, so if you did get your hands on them at a good price, don’t be stupid by selling them. Ride with the tide, hold, and enjoy your riches!
1) The 11th Commandment is to be unreasonable! I need to be unreasonable, am I being unreasonable? Is this a no-brainer?
Based on Alice Schroeder’s talk on Buffett.
1) Is there a wipeout risk? If so, don’t invest and move on immediately. Saves you time and protects your capital.
2) Will I get my 15% a year?
The first section of the checklist is based on a Charlie Munger interview from 2009 with the BBC. In the interview, Charlie explains a four item checklist that he and Warren run investment ideas through before they decide whether or not to buy a company or stock. A transcript of what Munger said about their checklist is below.
1) Do I understand this business and the industry? Is it in my circle of competence?
2) Does the business have intrinsic characteristics that give it a durable competitive advantage? Does the business have a moat?
3) Does the management in place have integrity and talent? I also like to add energy, as Buffett has said you want people with integrity, intelligence, and energy. So to slightly change Munger’s line on management… Does the management in place have integrity, talent, and energy?
4) Does the price make sense and provide a margin of safety?
Here is a transcript of what Munger said about this checklist:
We have to deal in things in that we’re capable of understanding. And then once we’re over that filter, we have to have a business with some intrinsic characteristics that give it a durable competitive advantage. And then of course, we would vastly prefer a management in place with a lot of integrity and talent. And finally, no matter how wonderful it is, it’s not worth an infinite price, so we have to have a price that makes sense and gives a margin of safety, considering the natural vicissitudes of life. That’s a very simple set of ideas. And the reason that our ideas have not spread faster is they’re too simple. The professional classes can’t justify their existence if that’s all they have to say. I mean, it’s all so obvious and so simple, what would they have to do with the rest of the semester?
I like to use the Munger 4 checklist as my first filter because of its simplicity and breadth. It will filter out most bad ideas very quickly and allow us to move on and continue our hunt for value.
1) Is the business model sustainable?
With this question we want to avoid a Valeant Pharmaceuticals situation. Valeant was making a ton of money by loading up on debt, buying other drug companies, severely jacking up prices, and not doing much research and development. This was not sustainable for society. Government and consumers pushed back and the company ran into tons of problems and the stock price tanked.
2) Does the business produce actual cash and not just accounting profits?
Here we want to avoid an Enron situation. We want to avoid companies whose books are being played around with. Does the company actually produce real cash flow? And is that cash flow close to the reported accounting earnings?
3) Does the business have a large market share and some kind of monopolistic situation?
4) Can competitors dictate the price of this company’s products or services?
For a long time in the airline industry, the dumbest competitor could lower their prices to an unsustainable level, take business away from you in the short term, and in the long term bankrupt the entire industry since their prices were not sustainable for anyone. We don’t want our dumbest competitor to dictate our prices.
5) Does the business rely heavily on the price of a commodity that is out of our control?
6) Are we going to have to compete with Jeff Bezos and Amazon?
We want to avoid having to compete with Jeff Bezos and Amazon. We probably won’t win.
6) Are we going to have to compete with China or another lower-cost competitor kind of country?
China wiped out Buffett’s Dexter Shoe investment. We want to avoid businesses whose products or services can be replicated by a lower cost country who would put us out of business.
7) Is the debt situation under control?
8) Are temporary tailwinds driving this company’s success? Is a bubble responsible for this company’s success?
Munger and Buffett bought Cort Furniture in 2000. It leased office furniture. The problem was that at the time Buffett and Munger were studying Cort, Cort’s revenue and free cash flow was abnormally high and attractive because of the internet bubble. Then the internet bubble popped and Cort’s business prospects fell. We want to avoid businesses that are reliant on temporary tailwinds and bubbles for their success.
9) If the stock market closed for ten years, would I be comfortable holding this company for ten years?
10) Would I be comfortable if all of my family’s net worth was in this one business? Could I sleep at night if this business was all I owned?
11) Would a child understand this investment decision?
Simplicity is the highest form of intelligence. We want to make simple decisions. Could we explain this investment decision to a child? Can we explain this investment decision in just a few sentences?
1) Is the PE attractive given the growth level?
2) Is this a value trap? Is a temporarily high earnings number causing the PE to be lower than it will be going forward?
3) Why will this company be worth more in the future than Mr. Market is offering it for today? Will the PE valuation rise? Will earnings rise? Will another company buy this business at a premium?
4) Why is Mr. Market offering me this great deal?
5) PE is important. But so is the “E” just on its own. The quality of those earnings, the durability of those earnings, the likelihood of those earnings continuing. Remember to consider that. E can go up, E can also go down. PE of 4 will be PE of 8 next year if earnings drop by half. And don’t forget, earnings can become losses as well.
1) If the company is paying a dividend, what is the payout ratio?
2) If the company is not offering a dividend, what would it’s payout ratio be if it paid a normal 2% dividend?
3) Is this a value trap? Is a temporarily high earnings number causing the dividend payout ratio to look more attractive than it will be going forward?
1) How is the union situation?
2) How is the pension situation?
1) Does this company make up a significant portion of their net worth?
2) Have insiders been buying or selling at similar prices?
We live in the age of artificial intelligence. It is good to remember AI is influencing my investment process and decisions every day.
Example 1 – Newspapers might find they get more clicks and ad revenue if they talk about electronic vehicles and batteries in their articles. This might lead them to consciously or unconsciously produce more content about the end of the internal combustion engine and the growth of battery power. This focus on battery power might lead me to believe we are closer to the end of oil and gas than we actually are. And I and Mr. Market might get too negative on oil companies.
Example 2 – Newspapers might find they get more clicks and ad revenue when they use the term “Great Depression” in their articles. This might lead them to consciously or unconsciously produce more content comparing any correction we have to the Great Depression. This might generate more fear than warranted during corrections. And this can lead to myself or Mr. Market making bad, fear-driven investment decisions. This happened in December 2018. Many articles and news stories compared that month to a time during the Great Depression. The comparison was not valid, but it did help lead to a big selloff and provided some good buying opportunities.
1. How is artificial intelligence influencing this investment idea?
2. How is artificial intelligence influencing Mr. Market’s view of this company and industry?