- The bigger the checklist, the bigger the resistance to adhere to it
- It is very important to bring together ideas (mental models) from different people and perspectives into the checklist to make us think in different dimensions. While this doesn't eliminate the risk of "black swans (unknowns) [Nasim Taleb]", it does help to reduce it.
- It is very important to bring together ideas (mental models) from different people and perspectives into the checklist to make us think in different dimensions. While this doesn't eliminate the risk of "black swans (unknowns) [Nasim Taleb]", it does help to reduce it.
- We tend to flow away into details when we solve a problem, and we 'forget' the big picture and the original problem we were solving - the same happened with my old checklist, it grew too big and I forgot the first reason why I needed a checklist!
The first reason we need checklist is to make sure we don't forget - and we don't go where we can die. Instead, I kept making a checklist which had so many items, without the focus on the main objective. Hence, I derive the following new checklist, with the main objective in mind - "don't go where you may die"...and yes, I'm getting more and more influenced by what Mr. Munger has said, and I'm reading and planning to read more of what the legendary investor has written, especially on behavioral finance.
So, we start, and once again, keep the following in front of mind:
- Don't go where you may die
- Invert, always invert, for there can be infinite ways to prove something, but only one exception is needed to disprove, hence the "process of elimination" or Inverting the problem is a more efficient way, and no wonder why science has used it for such a long time, successfully
Most importantly, the checkpoints are eliminating - if you can't provide a very convincing answer to move to next checkpoint, you should probably let go the stock and look for others :)
And before we start eliminating based on checklist, let us write down the following two point - our "initial perspective" about the business / stock:
TBD: Where do we add checks about finding scuttlebutt [Philip Fisher], behavioral biases, checks about black swans (really possible?). Pre-mortem?
Checkpoint 1: Is the business OUTSIDE your circle of competence [Charlie Munger]? Can you talk about it right after you're waked up from sleep? Do you understand the business well? Is it simple enough for an idiot to run [Peter Lynch]? Assume you're no better than an idiot!
Next, we try to eliminate the business based on management quality, for, a good manager may not be able to turn a bad business into a good one, but a bad manager can certainly damage a great business, irreversibly, and hence we must be very careful of the management.
Checkpoint 2: A good management is essential to keep a "good business" good, and hence, we must identify whether
a) Is management candid with shareholders? Have they done what they said in the past?
b) Does management act rationally?
c) Do management acts imply integrity?
d) Does management demonstrate good capital allocation skills, or they're stuck in institutional imperative? Examples being prudent dividend declarations when no avenues for cash, buying back shares to reduce stock dilution etc.
e) Does senior executive compensation include company stock options, and is it designed to bring sense of loyalty and belief? Are "insiders buying" the stocks when their market price goes down? Is promoter holding a clean holding or shares are pledged to "manage cash"?
Checkpoint 3: Does business possess a strong economic moat [Warren Buffet]? Check the following:
a) Do customers have a bargaining power that keeps an upper bound on prices and margin improvement is limited (cost cannot be lower than 0%)
b) Do suppliers have a bargaining power that keeps a lower bound on costs, such that margins are squeezed?
c) Risk of new entrants, who may play pricing wars and put pressure on pricing, i.e., does business have "earning power" like a brand value that allows it to maintain (or even increase) prices?
d) Is there an alternate product that poses a risk as a substitute to the product / service that business produces? Could it result in a permanent loss of revenue to the business?
e) Is the economic moat sustainable, or just due to luck?
Checkpoint 4: Since every business is essentially a system which takes in Cash and "is supposed to" generate more cash, such that the Return on Invested Capital (ROIC) is higher than Weighed Average Cost of Capital (WACC). Draw a "cash flow diagram" for the business explaining how it generates cash, and find out whether it has consistently been able to generate higher ROIC than WACC. Consider at least a period of last 5 years.
Checkpoint 5: Before we go further, we need to make sure that the financial health of the business is good. Answer these sub-points to find this out:
a) Is company sacrificing operating margins to grow revenue (lack of sustainable moat)? We want a business which is able to grow profits at least as fast as sales (maintain / grow operating profit margin).
b) Is operating cash flow poorer than profit (EBIT / EBITDA) on several occasions (consistently positive operating cash flow)?
c) How has working capital requirement changed over years? Is business generating cash faster than it needs (negative working capital)?
d) Is business generating good returns on capex, or it is burning precious cash in attempting to grow by capital spending (incremental return on capex)?
e) Is the debt on balance sheet concerning? Is most of operating cash leaking away in interest payments? Is business able to retire debt and gradually reduce interest burden? How long do you think will it take for the business to bring down debt to advantageous levels? Is dividend being regularly paid despite debt on the books? If so, is "Financial Leverage Index" > 1, indicating that return on investments is greater than cost of debt, and hence the leverage created due to debt is advantageous to the business, and it is good to pay dividends using generated cash, while keeping the debt at advantageous level.
Checkpoint 6: Stocks generally become value picks when they possess a healthy business with an able management, but suffering from a transient problem which drives the stock prices southwards. Is the business suffering from any such condition, and if so, why do you think this is not a permanent change (inflection point)? If you believe it is indeed an inflection point for the business, why do you think business is capable of turning it into an advantage [Andrew Grove]?
Checkpoint 7: Are there any negative catalysts foreseeable, that may impact the business prospects going forward, like a long term industry slowdown, increasing competition, or a regulatory change? On the other hand, what are the positive catalysts that'll bridge the gap between price and value?
At this point, you'd have either closed down, or successfully written down your understanding about the points above, and find that the business is healthy enough to pursue the analysis further. Before going further and performing a more detailed analysis, let us write down the expectation
Refer to a different post on guidelines for TBD stock valuation.
Risk Log: This is a concept used in large engineering projects. It is a way to write down risks involved in the project, and how to mitigate each of them. Borrowing this concept to investing, it'd make sense to create a risk log after having analyzed the points above, so that we know how much risk is involved in this investment, and are we going to get compensated enough for taking this risk [Charlie Munger]?
Stock Valuation: Do you expect the transient problem to go away / last for a small time, say a few months, and the temporary depression in stock can be used to make a small investment and benefit from it, i.e., do you consider this a stalwart [Peter Lynch]? If so, perform a "relative valuation" and find the "right buying price". If you've chosen this stock as any other form of valuation play (live a high dividend yielding stock), other than a long term holding, write down here and explain what is the right buying price, and why do you believe that you have adequate Margin of safety to justify this medium term investment's risk is well calculated.
However, if you still hold your "initial view" and plan to hold the stock for long term, perform a more detailed absolute and relative valuation and take sufficient margin of safety to address the concerns pointed out above in business analysis.
Opportunity Cost: Before taking the final decision, make sure that you're not overlooking the opportunity cost in this investment - can you allocate money elsewhere and get better returns with better margin of safety?
Final Decision: Does "initial view" still hold true? Is our analysis above somehow biased by those presumptions? After your analysis indicates that you should buy this stock, perform the following:
a) Keep the stock under "watch" for a week, and DO NOT buy or sell.
b) Post on blog and seek critical feedback. Seek contrary opinions, dis-confirming evidences, and try to find what you do not know [Charlie Munger].
c) At the end of the week, if your conviction in the business and stock's prospects is intact or stronger, go and BUY :-)
And before we start eliminating based on checklist, let us write down the following two point - our "initial perspective" about the business / stock:
- What is your main reason to look at this company? Write this down and once we analyze the business, we'll come back to see if our analysis is biased by this presumption [Anchoring bias, Charlie Munger]. If your reason is mainly a recent, sharp decline in share prices, try to find why so many people are selling, and if they know more than what you (prospective buyer) knows, or in other words, are you taking undue risk by investing into something with many unknowns?
- What kind of investment do you consider this business initially? Are you considering it as a long term story, or a medium term play (sorry, short term plays, i.e. for duration less than 3 months, are OUTSIDE the circle of value investors). Write down your initial thought in terms of [Peter Lynch] investment types - High Dividend Yielding, Stalwarts, Cyclical, Fast Grower, Turnaround story or an Asset Play?
TBD: Where do we add checks about finding scuttlebutt [Philip Fisher], behavioral biases, checks about black swans (really possible?). Pre-mortem?
Checkpoint 1: Is the business OUTSIDE your circle of competence [Charlie Munger]? Can you talk about it right after you're waked up from sleep? Do you understand the business well? Is it simple enough for an idiot to run [Peter Lynch]? Assume you're no better than an idiot!
Next, we try to eliminate the business based on management quality, for, a good manager may not be able to turn a bad business into a good one, but a bad manager can certainly damage a great business, irreversibly, and hence we must be very careful of the management.
Checkpoint 2: A good management is essential to keep a "good business" good, and hence, we must identify whether
a) Is management candid with shareholders? Have they done what they said in the past?
b) Does management act rationally?
c) Do management acts imply integrity?
d) Does management demonstrate good capital allocation skills, or they're stuck in institutional imperative? Examples being prudent dividend declarations when no avenues for cash, buying back shares to reduce stock dilution etc.
e) Does senior executive compensation include company stock options, and is it designed to bring sense of loyalty and belief? Are "insiders buying" the stocks when their market price goes down? Is promoter holding a clean holding or shares are pledged to "manage cash"?
Checkpoint 3: Does business possess a strong economic moat [Warren Buffet]? Check the following:
a) Do customers have a bargaining power that keeps an upper bound on prices and margin improvement is limited (cost cannot be lower than 0%)
b) Do suppliers have a bargaining power that keeps a lower bound on costs, such that margins are squeezed?
c) Risk of new entrants, who may play pricing wars and put pressure on pricing, i.e., does business have "earning power" like a brand value that allows it to maintain (or even increase) prices?
d) Is there an alternate product that poses a risk as a substitute to the product / service that business produces? Could it result in a permanent loss of revenue to the business?
e) Is the economic moat sustainable, or just due to luck?
Checkpoint 4: Since every business is essentially a system which takes in Cash and "is supposed to" generate more cash, such that the Return on Invested Capital (ROIC) is higher than Weighed Average Cost of Capital (WACC). Draw a "cash flow diagram" for the business explaining how it generates cash, and find out whether it has consistently been able to generate higher ROIC than WACC. Consider at least a period of last 5 years.
Checkpoint 5: Before we go further, we need to make sure that the financial health of the business is good. Answer these sub-points to find this out:
a) Is company sacrificing operating margins to grow revenue (lack of sustainable moat)? We want a business which is able to grow profits at least as fast as sales (maintain / grow operating profit margin).
b) Is operating cash flow poorer than profit (EBIT / EBITDA) on several occasions (consistently positive operating cash flow)?
c) How has working capital requirement changed over years? Is business generating cash faster than it needs (negative working capital)?
d) Is business generating good returns on capex, or it is burning precious cash in attempting to grow by capital spending (incremental return on capex)?
e) Is the debt on balance sheet concerning? Is most of operating cash leaking away in interest payments? Is business able to retire debt and gradually reduce interest burden? How long do you think will it take for the business to bring down debt to advantageous levels? Is dividend being regularly paid despite debt on the books? If so, is "Financial Leverage Index" > 1, indicating that return on investments is greater than cost of debt, and hence the leverage created due to debt is advantageous to the business, and it is good to pay dividends using generated cash, while keeping the debt at advantageous level.
Checkpoint 6: Stocks generally become value picks when they possess a healthy business with an able management, but suffering from a transient problem which drives the stock prices southwards. Is the business suffering from any such condition, and if so, why do you think this is not a permanent change (inflection point)? If you believe it is indeed an inflection point for the business, why do you think business is capable of turning it into an advantage [Andrew Grove]?
Checkpoint 7: Are there any negative catalysts foreseeable, that may impact the business prospects going forward, like a long term industry slowdown, increasing competition, or a regulatory change? On the other hand, what are the positive catalysts that'll bridge the gap between price and value?
At this point, you'd have either closed down, or successfully written down your understanding about the points above, and find that the business is healthy enough to pursue the analysis further. Before going further and performing a more detailed analysis, let us write down the expectation
Refer to a different post on guidelines for TBD stock valuation.
Risk Log: This is a concept used in large engineering projects. It is a way to write down risks involved in the project, and how to mitigate each of them. Borrowing this concept to investing, it'd make sense to create a risk log after having analyzed the points above, so that we know how much risk is involved in this investment, and are we going to get compensated enough for taking this risk [Charlie Munger]?
Stock Valuation: Do you expect the transient problem to go away / last for a small time, say a few months, and the temporary depression in stock can be used to make a small investment and benefit from it, i.e., do you consider this a stalwart [Peter Lynch]? If so, perform a "relative valuation" and find the "right buying price". If you've chosen this stock as any other form of valuation play (live a high dividend yielding stock), other than a long term holding, write down here and explain what is the right buying price, and why do you believe that you have adequate Margin of safety to justify this medium term investment's risk is well calculated.
However, if you still hold your "initial view" and plan to hold the stock for long term, perform a more detailed absolute and relative valuation and take sufficient margin of safety to address the concerns pointed out above in business analysis.
Opportunity Cost: Before taking the final decision, make sure that you're not overlooking the opportunity cost in this investment - can you allocate money elsewhere and get better returns with better margin of safety?
Final Decision: Does "initial view" still hold true? Is our analysis above somehow biased by those presumptions? After your analysis indicates that you should buy this stock, perform the following:
a) Keep the stock under "watch" for a week, and DO NOT buy or sell.
b) Post on blog and seek critical feedback. Seek contrary opinions, dis-confirming evidences, and try to find what you do not know [Charlie Munger].
c) At the end of the week, if your conviction in the business and stock's prospects is intact or stronger, go and BUY :-)
Dear Sunny
ReplyDeleteIf you are investing in India....if the checklist number 9 is forwarded to number 1....don't you believe that it will help in pruning the list in a big way.
Thanks Reni, indeed great point, have modified the checklist...
Delete