Checklist investing is a simple process with tremendous benefits. Checklists can protect you from yourself, and propel you towards investment success.
In 2001 a doctor working at John Hopkins Hospital, Peter Provonost, wanted to tackle the problem of infections. He laid out the steps needed:
- Wash hands with soap
- Clean patient’s skin with antiseptic
- Place sterile drapes on patient
- Wear sterile mask, hat, gown and gloves
- Place sterile dressing over catheter site
That’s it – just five steps. Things doctors and nurses already know, and yet Provonost felt the need to create a checklist. Why?
It turns out that doctors were routinely skipping steps. Provonost asked nurses to stop doctors if they skipped steps and it helped tremendously. After a year of this system being in place, the ten-day infection rate decreased from eleven percent to zero. The checklist method of preventing infections prevented at least eight deaths and saved two million dollars in costs.
Checklist Investing: Why Value Investors need Checklists
It’s easy to take shortcuts, even when you are a highly trained professional.
In the hospital situation described above, checklists had a dramatic impact because it helped the doctors and nurses focus on the small things that, when added up over many interactions, had a big effect on overall infection rates. A checklist can help make sure these mundane little things are done every time, all the time.
Some investors fall prey to their emotions. They get caught up in the hype of a new tech stock or sell off shares because of fear. It’s commonly known that the S&P 500 outperforms the average investor. That happens because rather than adopt a simple buy-and-hold strategy, investors allow their emotions to get the better of them – causing them to make sub-optimal decisions.
Investors can benefit from outsourcing their discipline to a checklist in the way pilots do. Pilots use checklists prior to take-off to make sure everything is functioning as it should, and investors can use a checklist to make sure all is in order prior to investment.
Checklists are great for reducing human error, but they are also valuable in that they provide a type of documentation. Imagine one follows the checklist prior to investing in a company and it doesn’t work out. A smart, motivated investor can examine what went wrong and see if another item needs to be added to the checklist. For example, maybe you rushed in without making sure the business had a true economic moat. Do your post-mortem and then add that step on the checklist.
You’ll never make that mistake again.
Checklist Investing: What goes on the Checklist?
Investors such as Warren Buffet, Charlie Munger, Guy Spier and Mohnish Pabrai all tout the virtues of using checklists when evaluating a company. In a 1977 letter to shareholders Warren Buffett outlined his checklist philosophy.
“We select our marketable equity securities in much the same way we would evaluate a business for acquisition in its entirety. We want the business to be (1) one that we can understand, (2) with favorable long-term prospects, (3) operated by honest and competent people, and (4) available at a very attractive price.”
If these veteran value investors are doing it, then maybe you should consider it too.
Your checklist can be separated into different parts, or focused on just one area based on how you like to work. The first part of a value investor’s checklist might be devoted entirely to finding stocks using a screener, laying out the criteria for doing so (Price to book <1.5, P/E Ratio < 15, etc.)
The next part of the checklist can focus on research and helps the investor to further qualify the stocks that make it through the screener. At this point your checklist may have look like this:
- Plot the company’s earnings over time
- What do key metrics look like: operating margin, gross margin, revenue
- Does the company perform better than its industry peers?
- Does the business have ten straight quarters of increasing earnings?
- Does Free Cash Flow tracking Earnings per Share? If not, why?
- Can it be purchased at significant discount to intrinsic value?
Once you work through that and are more or less ready to invest you can go through your final “pre-flight” checks.
- Who’s selling and why? Someone is making a mistake here, either the buyer or the seller, so take a minute
- Conduct a pre-mortem: what are all of the ways this investment could fail
- Stress test your investment thesis by getting outsider input
These are all examples of items that can make their way onto an investor’s checklist. Your checklist is going to be different from someone else’s – it’s a highly individualized and personal tool. Your checklist may ask you to input your exit price ahead of time, while another investor completely eschews that step.
Checklist Investing: The Power of Checklists
Garbage in, garbage out.
We’ve heard this phrase before. A checklist is only as good as the items on it. Good checklists are precise and efficient, while bad checklists are vague, too long and confusing to use. Don’t try to spell out each step – just use the checklist to provide reminders of the most critical and important steps.
A checklist is also not a replacement for human judgement and careful analysis. It is a tool to help during the investing process, and can aid in refining your investing methods the more you use it.
Checklists are great in the sense that they act as a check on our individual lapses in judgement. One needs to be intelligent, and a good analyst to be a successful investor, that is certain, but doing the small things right, day in and day out, will give you an edge in the market far surer than swallowing an advanced quantitative methods textbook will.
Do yourself a favor, use a checklist.
Jiva Kalan is a writer whose work has been featured on DailyFinance, the Wall Street Survivor, Plousio and Financial Choice.