The investment process we follow at Mayar Capital rests on many pillars, among the very important ones is to think of risk before return. The key driver of permanent loss of capital is paying prices above the intrinsic value of assets either because the buyer is driven by greed, or because they have miscalculated intrinsic value. Our goal is to avoid both kinds of mistakes as much as humanly possible.
This emphasis on minimizing mistakes may be one of the least appreciated tricks in successful investing. Charlie Munger offers some insight here, “It is remarkable how much long-term advantage people like [Warren Buffett and myself] have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.”
A very important way to minimize investment mistakes, is to be very cognizant of one’s fallibility. While I, like most fund managers, have yet to be accused of being a humble human being, I try to employ every tool at my disposal to minimize the encroachment of my ego into our investment process.
Using tools such as checklists are very important in helping us achieve that. Charlie Munger has talked many times about the benefits of using a checklist. He said, “No wise pilot, no matter how great his talent and experience, fails to use his checklist.” And in another instance, “I’m a great believer in solving hard problems by using a checklist. You need to get all the likely and unlikely answers before you; otherwise it’s easy to miss something important.”
We have designed our checklist and investment process with mistake-minimization in mind. When an investment idea comes through our funnel, the first few steps in our process are totally focused on “killing the idea”. This serves two purposes; the first is trying to avoid as many obvious mistakes as possible. That would include companies with things like accounting irregularities and poor governance. The second purpose is more practical; it allows us to optimize the time we spend on research ideas by avoiding as many potential dead-ends as early as possible. We will naturally make mistakes from time to time, but I believe that starting out with this mindset gives us a tremendous edge over time.
Like everything in life, however, our filtering process comes with a cost, which is the presence of some false positives (Type II errors); companies that we eliminate for red flags that are actually good investments. We are willing to accept that cost to avoid the really big mistakes. Our checklists are not set in stone, however. Every time we make a mistake, we will go back and adjust our checklist with the goal of always improving its outcomes.
Another trick we use in our checklist is breaking down complex questions into simpler ones. There is strong evidence that doing that helps avoid some behavioral biases that we as human beings are prone to. For example, instead of asking ourselves a question like “are there any accounting red flags,” we break down that question into more than a dozen “sub-questions” such as “did Days Receivables have any inexplicable big moves in any year in the past 10 years?” We then score each one of these “sub-questions” on a 4-point scale and come up with an aggregated score for the whole “big” question of whether there is any obvious evidence of accounting irregularities.
This method of breaking down questions produces less bias than simply asking ourselves the “big” question. Of course, answering this question won’t rule out all possible account irregularities, but it will catch a lot of them very quickly, allowing us to “kill” many potential ideas within minutes instead of spending days studying them. As an important side benefit, I also believe that by getting us to first answer questions about bad stuff, we are less likely to be overexcited by the positive stuff.
Bear in mind that using a checklist is not the same as automating a process. For starters, a lot of the questions in the checklist need subjective judgment to be answered. The goal of the checklist is not to be a substitute for rational thought but to act as a systemic guide to standardize the thought process which, in turn, helps us avoid missing something important, minimizes behavioral biases, and creates a feedback mechanism to learn from mistakes. This last benefit is why our checklist is a “living document” continuously updated based on learnings from both our experiences and the experiences of others. Over time, we believe, the checklist “hit rate” should continuously improve.
This post has been excerpted from the Mayar Fund March 2016 Letter.
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