This week, I am reviewing The Checklist Manifesto: How to Get Things Right by Atul Gawande. This is an ongoing process, so send me your feedback as to how I can provide you with more value in reviewing these books (send me an email here or leave a comment below).
At first glance, today’s book may not appear to be related to investing, but I assure you that its key teachings can and should be applied to your investment decision-making process (and in fact are used by many top value investors, including Mohnish Pabrai, author of The Dhandho Investor and Guy Spier of Aquamarine Capital). The reason I can make such a normative statement with confidence is that the nature of the challenges facing investors allow these challenges to be best handled through the use of checklists. You may be wary of this claim, and trust me I started the book with the same feelings, but by the end I was a convert to Atul Gawande’s Checklist Philosophy (and I think you will be too, if you read it!).
Types of Problems
Philosophers Samuel Gorovitz and Alasdair MacIntyre studied human fallibility and separated mistakes into two broad categories. Those failures that are necessary – the problem was simply beyond our capacity – and those that are not. Among the unnecessary failures, there are problems of ignorance, where we simply do not understand the world enough, and problems of ineptitude, where we understand the problem and how to remedy it but fail in execution.
By their nature, we cannot solve necessary failures, and science is rapidly filling in the problems of ignorance. But perhaps most inexcusable are those problems that we can foresee and understand how to solve, yet we have only ourselves to blame due to our inexpert execution. This, in my opinion, is the realm of the challenges we face in investing:
Here, then, is our situation at the start of the twenty-first century: We have accumulated stupendous know-how. We have put it in the hands of some of the most highly trained, highly skilled, and hardworking people in our society. And, with it, they have indeed accomplished extraordinary things. Nonetheless, that know-how is often unmanageable. Avoidable failures are common and persistent, not to mention demoralizing and frustrating, across many fields—from medicine to finance, business to government. And the reason is increasingly evident: the volume and complexity of what we know has exceeded our individual ability to deliver its benefits correctly, safely, or reliably. Knowledge has both saved us and burdened us.
As investors, we face greater transparency in corporate disclosures than all previous investors. We have access via the internet to more market research, product information, and competitor activity than at any time in history, and we have free or inexpensive access to investment analysis tools that were reserved for professional investors with big research budgets until recently. Yet, managing this information has presented its own challenges. It is easy to skip steps. In most cases, to skip a step doesn’t prove fatal to the investment thesis. Until it does.
The Checklist Manifesto explains the types of situations where checklists are effective, and how effective checklists can be designed. It may seem childish to attempt to reduce investing to a simple checklist, but consider this: Gawande has proven beyond a doubt, with the aid of the World Health Organization, the effectiveness of checklists in hospital operating rooms around the world, which face an unending supply of unique, time sensitive problems. You can look at two of the WHO’s checklists here and here (also check out a sample checklist used for Boeing 777 in normal flight here). The realm of investing, with the opportunity to sit back and ponder the problem without fear of killing another human being, seems relatively simple in comparison.
In a complex environment, experts are up against two main difficulties. The first is the fallibility of human memory and attention, especially when it comes to mundane, routine matters that are easily overlooked under the strain of more pressing events. …
A further difficulty, just as insidious, is that people can lull themselves into skipping steps even when they remember them. In complex processes, after all, certain steps don’t always matter.
Application for Investors
Near the end of the book, Gawande discusses conversations he had with three value investors: Mohnish Pabrai, Guy Spier, and a third unidentified portfolio manager. All three note the problem of “greed mode”
Every week or so, though, [Pabrai] spots [an investment] that starts his pulse racing. It seems surefire. He can’t believe no one else has caught onto it yet. He begins to think it could make him tens of millions of dollars if he plays it right, no, this time maybe hundreds of millions. “You go into greed mode,” he said. …And that, Pabrai said, is when serious investors like himself try to become systematic. They focus on dispassionate analysis, on avoiding both irrational exuberance and panic. They pore over the company’s financial reports, investigate its liabilities and risks, examine its management team’s track record, weigh its competitors, consider the future of the market it is in—trying to gauge both the magnitude of opportunity and the margin of safety.
[Pabrai] was disciplined. He made sure to take his time when studying a company. The process could require weeks. And he did very well following this method—but not always, he found. He also made mistakes, some of them disastrous. These were not mistakes merely in the sense that he lost money on his bets or missed making money on investments he’d rejected. That’s bound to happen. Risk is unavoidable in Pabrai’s line of work. No, these were mistakes in the sense that he had miscalculated the risks involved, made errors of analysis. For example, looking back, he noticed that he had repeatedly erred in determining how “leveraged” companies were—how much cash was really theirs, how much was borrowed, and how risky those debts were. The information was available; he just hadn’t looked for it carefully enough. In large part, he believes, the mistakes happened because he wasn’t able to damp down the [greed mode]. …
Yet no matter how objective he tried to be about a potentially exciting investment, he said, he found his brain working against him, latching onto evidence that confirmed his initial hunch and dismissing the signs of a downside. It’s what the brain does. “You get seduced,” he said. “You start cutting corners.”
These investors have implemented checklists in their investment decision-making process which have shown measurable improvements. While it is difficult to determine with certainty whether the checklists were the sole cause of their improved performance, the key comes from the increased efficiency the three investors have noticed. By relying on checklists, they are able to move systematically through the investment analysis, with little wasted time or effort. Each step taking on a rhythm that makes them more effective in time management without sacrificing analytical depth.
In crafting your own checklist, Gawande has published a meta “Checklist for Checklists” here, though I think the book helps elucidate some of the points.
Who should Read This Book
I was a skeptic when I first picked up this book in that I did not think I would have many takeaways that I could apply to my investment analysis. Simply put, I was wrong. I have since suggested to several people I know that they should read it, and I will do the same for you. If you are a fundamental investor, you would be well advised to focus on your investment process, and I believe systematizing that process in the form of a checklist can be extremely useful. This book will help you do that. In terms of improving investment processes, I would say this book has been the most useful I have read.
If you have read this book, I’d love to hear your experiences applying it to your investment process!