Checklists have gained credence over the years, not only in domains such as air travel and surgery but also in investing. Atul Gawande’s The Checklist Manifesto has inspired professionals in many process-oriented fields to think more strategically about the investment decision-making process.
A valued member of our global community of intelligent investors is Michael Shearn, author of The Investment Checklist: The Art of In-Depth Research, and managing partner of the Compound Money Fund. As Michael reminds us, many investors tend to make buy and sell decisions based on hunches, recommendations from other investors, or isolated facts. By doing so, the investment decision-making process becomes dangerous because not enough time is dedicated to thoroughly research the investment under consideration.
Instead, as Michael points out, investment decisions should be based on understanding the value of a business through in-depth research. An essential part of good in-depth research is a good investment checklist. However, as Michael also points out, even investment checklists and diligent research are fraught with pitfalls. An obvious pitfall is commonly referred to as paralysis through analysis: losing oneself in endless data points that are irrelevant to the investment thesis.
During our exclusive conversation, Michael reveals how to employ checklists successfully in one’s investment process and how to avoid the many misuses of checklists in investing. We are pleased to share the following two excerpts below: one on the uses and misuses of investment checklists, the other on how to employ a checklist to successfully evaluate a company’s management. The full video of our conversation, including past case studies and a discussion of an investment case study, is available in The Manual of Ideas Members Area.
Michael Shearn on the Uses and Misuses of Checklists
Says Michael Shearn:
“What happened is when I first started investing I found that if a company put out a negative news release or the stock price dropped, I’d have a very bad reaction to it and I’d be running around like Chicken Little, the cartoon character, thinking the sky was falling. And I just said I’ve got to stop having these negative reactions. So, what I started saying was the problem was that I didn’t understand enough about the businesses that I was invested in because I wasn’t in a position to interpret the news events as they were coming out or to determine whether it was a real issue, or maybe just a temporary issue.
So, I started coming up with a series of questions that I would ask to increase my knowledge in a business so that I’d be in a better position to understand how to interpret these news events and understand more about the company. But it actually ended up being somewhat of a mistake because I started doing this for a lot of years where I was just answering questions to answer questions.
I did get to know more about the businesses I was invested in but the downside was that the amount of questions became cumbersome and so in a way the checklist lacked a purpose. I started asking, what is the purpose of thing? Is it just to answer questions? I am learning more about the businesses but what is the purpose?
I started thinking about the purpose of investing. And really the purpose of investing is to understand the value of whatever you’re buying because if you understand value, you know when to buy, you know when to sell, or when to hold. I started thinking these questions instead of increasing my knowledge of the business should be more about understanding how to value the business. In order to value a business, you need to know something about the stability of earnings and more importantly how those can change in the future.
You’ve got to ask questions about the company in order to understand and be able to answer whether it’s a stable earnings and how they’re going to change. Things like, what kind of sales it makes? Is it recurring revenue or is it one-time sales like patio furniture? What are the future growth opportunities? As you go through these questions, you’re actually learning that valuation’s actually quite dynamic. It’s not static. It changes. For example, depending on the type of business, if you change a management team it’s going to have a profound effect on the future earnings of the business.
A case in point is J.C. Penney [JCP]. Ron Johnson, when he came in at a very short period of time succeeded in decreasing 25% of the sales at J.C. Penney. So, a management change can have a very big effect on the future earnings of a business. It’s really about understanding and just looking at a business in a more holistic way, that’s the purpose of these questions. Asking questions about management, what kind of management team you’re partnered with?Looking at it from the customer viewpoint or looking at it within the context of its industry.
For example, in the past I would spend too much time trying to determine if a business had a competitive advantage. Over time, I started learning that actually the most value in a stock or investment comes from as a business is building its advantage, not after it already has one. And so a lot of the questions are centered around understanding if a business is in the process of building its advantage. You can think of Microsoft [MSFT], the biggest gains came when Bill Gates was managing that business and building it rather than now that it already is a quasi-monopoly that already has an advantage. That’s one thing about the checklist is it allows you to look at a business from a multiple stakeholder, as you will, viewpoint and better understand how value can change if any of those factors changes.”
Michael Shearn on How to Assess Company Management
Says Michael Shearn:
“It’s never enough, you’re always learning something new. We look for first-class managers. Now within that group there’s some that just stand out. You can look at Bruce Flatt, the CEO of Brookfield Asset Management [BAM] as an example. You ask him what his hobby is and it’s collecting shares of Brookfield. He’s never sold any shares. We looked at his personal lifestyle, it’s not changed. He owns the same house he’s had in New York, or same apartment, same one in Toronto.
Money doesn’t mean very much to him yet he’s worth half a billion dollars. You could look back at his decisions. One thing again with Factiva, you get a lot of articles and how he acted in certain situations. On September 11th, when the twin towers fell, Brookfield Properties owned the four World Financial Center towers around that and they were damaged. What Bruce did the day he heard of it, he got in a car and got down to New York, and started managing from the field. Basically figuring out what is going on with the buildings, they were saying they were structurally damaged in the news and he went in there and checked it out for himself to see if they were. Then they had some subsidiaries that provided plywood and certain materials, and he had those shipped immediately so that they could get their tenants back up and running.
When you read stories like that you know you’re dealing with a first-class manager. They just pop to you, and it’s rare when they do. The most difficult are those that are long tenured. They’ve been at the business for a long time, they weren’t the founders. The founders are easier to analyze. You look at the proxy statement and there are a lot of indicators of who you’re dealing with. But then the more difficult ones are again these people who’ve been in the business for a long period of time.
What we’re looking for is making sure, for example, integrity is very important and it’s so easy to say I want to find somebody with integrity. The only way you’re going to know if somebody has integrity is if their character’s been tested. What did they do in a difficult time? That’s the only way. One of the questions on that checklist is define the moment of integrity because I can’t just have a gut reaction and meet somebody, and think they have integrity because if that happens I may be biased. They may look like me and act like me and they’re great, I like them. You look for these moments of integrity.
I’ll talk about a moment of integrity. Dave Gold who was the founder of 99 Cents Only Stores, which is a dollar retailer based out of Los Angeles. Unfortunately he died about a week and a half ago. I remember reading articles about Dave and one of them, I ran into this negative article saying the SEC was investigating him because he had bought back a business from 99 that 99 had acquired two years before. The SEC was basically accusing him of self-dealing as well as shareholders saying you’re buying this cash cow from the company and putting it into your pocket.
I kept reading the articles and I learned two years later that what had happened is that Dave bought this business because it was a mistake. He bought it back from the company and he paid two times what they had paid for it because during the time it had sustained operating losses but Dave felt so bad for the shareholder. He really did that he bought back this mistake because it was his idea to make this acquisition. You run into something like that, you don’t need to know more. With that kind of action, they have integrity.
If you don’t see those actions it gets a lot more difficult and sometimes you have to wait. If capital allocation is important to the business, you have to define what’s very important to this business. And say if it’s a spinoff, it’s a new CEO and the capital allocation decisions were made at the conglomerate level, you have to wait to answer that question and maybe you don’t invest as much, maybe you wait for certain information. Again, if it’s a very capital-intensive business and that’s very important to that business to create value in the future, then you just wait.
In those cases, we just wait to see a track record like how are they allocating capital because if we go and assume that they’re good capital allocators without any track record, that’s when we make a mistake. That’s what we’re trying to answer. Every business has certain things that are very important to it that you have to figure out what that is and see if you see a track record or evidence to stand by your thesis.”
Michael Shearn, Mohnish Pabrai, and Guy Spier on Checklists
In 2014, we had the pleasure of moderating at exclusive ValueConferences session on checklists with Michael Shearn, Mohnish Pabrai, and Guy Spier. Mohnish and Guy are well-known as two prominent value investing practitioners who embrace the use of checklists. Echoing statements made by Charlie Munger, Mohnish and Guy have concluded that following a pre-defined list of research-related questions lowers the likelihood of mistakes.
A Guide to Investment Checklists – Brian Hertzog
On the Use of Investment Checklists – Christian Olesen
The Four Sections of a Checklist – Pope Brar
The Risk Section of a Checklist – Pope Brar
Case Studies in Assessing Management – Michael Shearn