Mohnish Pabrai of Pabrai Investment Funds and Guy Spier of Aquamarine Capital Management have both made a case for the use of checklists in investing. Here is an exchange with Spier from an interview with Portfolio Manager's Review earlier this year:
Q: When it comes to stock selection, you have talked about the importance of checklists. Why are they so crucial, and what are some of the key items on your checklist?
A: Those readers who have seen my two or three presentations know that I have talked about checklists. All of these ideas have emerged from conversations with Mohnish Pabrai, who noticed an article by Atul Gawande in The New Yorker with profound implications for investors. I'll share the basic insight that I have had as a result of these conversations: I think that we just have to acknowledge that there are some individuals out there — I think Warren Buffett in the investment world is one, Ajit Jain in the insurance world is another — who have a very particular ability to rationally analyze a situation in spite of crazy things going on in the world.
Most of us do not have that specific wiring. In spite of that, we can still improve our decision-making an awful lot by using checklists. The main way that I see it is that the investment world, either by design or by nature — and I think it is a combination of the two — throws up plenty of information that is designed to trigger one of two areas in the brain.
One is the threat detection fear mechanism, which throws up a very primeval response that has evolved within us for a very long time. It is one of the oldest parts of our brain — the fight-or-flight response. When we see something that makes us fearful, and we don’t have time to act, analyze and make weighted judgments, we have to decide either to run or to stay. We all know days in the market where that part of an investor’s brain is dominating and in which share prices can move around rather dramatically when compared to what appears to be very small amounts of news. So that is one sort of mode that the markets can be in, which is really the psychological mode of the majority of the participants in the market.
Then there is another side, which is irrational exuberance, as Alan Greenspan has described it, where the part of the brain that is being triggered is, as I’ve seen it described in various articles, the pleasure center of the brain. It turns out that the part of the brain we stimulate by the expectation of future profits is not that far away or dissimilar to the part of the brain that is stimulated, or lights up in CAT scans, when cocaine addicts either contemplate or are taking cocaine. These are very powerful centers.
Whether it is the fight-or-flight or the expectation of pleasure centers, the effect of both is to short-circuit rationally considered thoughts. They undermine the path of the brain that can make weighted, careful judgments about probabilities and about expectations. My perception is that it is the rational neocortex from which flow the very best investment decisions. Unfortunately, the world in which we operate is a minefield of opportunities to get caught up either by the fight-or-flight or by the pleasure center. So to the extent that somebody will talk about an investment being good when one is trembling with greed – I would not subscribe to that because trembling with greed implies that your greed and pleasure mechanisms in the brain are dominating the rational side.
I think that somebody like Warren Buffett is naturally wired not to be in either of those two extremes and spends his time in the happy middle. I think that what the rest of us human beings can do to train ourselves to be in that happy middle is use checklists. A checklist pulls us away from the kinds of actions that we would take if we were in either fight-or-flight or greed modes. So that is the basis for checklists.
The example I have given in talks is an airplane that is crashing. There is no question that checklists have been extremely helpful in reducing airplane accident rates. What it does is it brings the brain back to the place where one can make rational decisions.
Q: What advice would you give other investors on building an effective checklist? Is it primarily a product of past investment experience, i.e., mistakes — and if so, how does one differentiate between mistakes that should go on the checklist versus others that are simply unavoidable?
A: Obviously, in terms of building checklists, there is no question that the place to go is past mistakes. Not only one’s own past mistakes, but also to look at other investors’ past mistakes and see what those mistakes were. It seems to me, and it is a process that I am still going through, that the more specific the checklist item is the better.
I can give an example of an investment that I made where the CEO of the corporation was going through a divorce — a long, protracted and bitter divorce. In retrospect, when I look at what went wrong in that investment, I can see very clearly that the fact that he was going through this divorce meant that the CEO was much less able to focus both on the needs of the business and on capital allocation decisions. His whole investment, in fact, would have gone to his former wife if she had won the lawsuit. The whole company would not have belonged to him. So his emotional ties to the company were predicated on the outcome of the court case. His desire to make money for the company’s shareholders would have been hugely diminished if his wife had ended up controlling the company. So one of the items in my checklist is whether the CEO is going through major divorce proceedings, in which case I would tend to weigh that very heavily.
To give an example of checklist items that don’t come from individual or personal mistakes is the example of Coca-Cola and its ownership by Berkshire Hathaway. There was a period earlier this decade when Coca-Cola was trading at a multiple which was as high as 40 to 45 times earnings. We all know that Warren Buffett did not sell. I think that there is at least one statement in the public domain where he said that if given the chance to revisit that decision, he would have sold Coca-Cola.
I ask myself to what extent he was unable to make that choice at the time and execute a sale because he had already made public statements in the annual reports and elsewhere that Coca-Cola was an inevitable and permanent holding of Berkshire Hathaway. Making such a public statement is a very powerful driver of commitment consistency bias, which may have affected his ability to make rational decisions.
So what would go on the list? You would ask yourself the question, “Have I made public statements about this?” Obviously, the note to self is, don’t make public statements about positions you own that will predispose you towards owning them or not owning them or being able to sell them or not.
There is another example from Berkshire Hathaway, which is the acquisition of Cort Furniture, which did not turn out to be the phenomenal acquisition that some commentators suggested it was. It seems that one of the reasons is that Cort was in the business of renting furniture to people who had a temporary need. Cort benefited dramatically from the Internet bubble in which many companies were setting up offices that needed to be furnished rather quickly and had large amounts of money to spend. In the aftermath of the Internet bubble, the demand from that portion of the market was extremely attenuated and Cort’s earnings power was diminished significantly.
The basic insight that seems to have not been applied in the Cort acquisition, which has gone onto my checklist, would be, “Am I investing in an industry or a company that is benefiting from another industry that has just experienced a dramatic boom?” Another way of saying the same thing would be, “Am I investing while looking in the rear view mirror rather than looking at the road ahead?” Whether they are yours or somebody else’s, I think that mistakes are the most fruitful place to look for checklist items.
It is important to note that checklists are not wish lists. Obviously, we are looking for certain kinds of businesses and certain types of investment. That is what we are navigating for. The checklists are very specific items that are designed to bring our brains away from the influence of greed and fear. I would argue that I am not sure a mistake that is unavoidable is a “mistake” in terms of your question. I think that there are so many ways where one can go wrong. In retrospect we can see what we should have known. It is hard to control for the unknowable, because it is by definition unknown. The more one can throw onto an investment checklist, the better.
It is worth pointing out that no investment is going to pass every single investment checklist item. What the investment checklist will do is to throw up the issues that one should be focused on. Then an investor can try to weigh them to decide if they negate the benefits of the investment or not. One of the things that the checklist has done for me is to bring up the basic question: “Are we stretching to make the investment?” In this way investing is very similar to golf. In golf, one never hits a good shot if one is stretching or pushing oneself. The best golf shots come when we are acting well within our capacity. To that extent, a term that I do not think should apply to investing is, “I spent time getting comfortable.” The investment should leap out to you. If you are trying to get comfortable with something or it takes too long for you to get comfortable with it, then it is probably not a good investment. You shouldn’t have to get comfortable. That implies to me that I would be stretching.
In the above discussion, Spier credits Pabrai and Gawande for the checklist idea. Here is an excerpt from a seminal article by Gawande in the December 2007 issue of The New Yorker, in which Gawande described how checklists had transformed intensive care for the better:
Read a new article by Gawande on the U.S. healthcare overhaul.
If a new drug were as effective at saving lives as Peter Pronovost’s checklist, there would be a nationwide marketing campaign urging doctors to use it.
The damage that the human body can survive these days is as awesome as it is horrible: crushing, burning, bombing, a burst blood vessel in the brain, a ruptured colon, a massive heart attack, rampaging infection. These conditions had once been uniformly fatal. Now survival is commonplace, and a large part of the credit goes to the irreplaceable component of medicine known as intensive care.
It’s an opaque term. Specialists in the field prefer to call what they do “critical care,” but that doesn’t exactly clarify matters. The non-medical term “life support” gets us closer. Intensive-care units take artificial control of failing bodies. Typically, this involves a panoply of technology—a mechanical ventilator and perhaps a tracheostomy tube if the lungs have failed, an aortic balloon pump if the heart has given out, a dialysis machine if the kidneys don’t work. When you are unconscious and can’t eat, silicone tubing can be surgically inserted into the stomach or intestines for formula feeding. If the intestines are too damaged, solutions of amino acids, fatty acids, and glucose can be infused directly into the bloodstream.
The difficulties of life support are considerable. Reviving a drowning victim, for example, is rarely as easy as it looks on television, where a few chest compressions and some mouth-to-mouth resuscitation always seem to bring someone with waterlogged lungs and a stilled heart coughing and sputtering back to life. Consider a case report in The Annals of Thoracic Surgery of a three-year-old girl who fell into an icy fishpond in a small Austrian town in the Alps. She was lost beneath the surface for thirty minutes before her parents found her on the pond bottom and pulled her up. Following instructions from an emergency physician on the phone, they began cardiopulmonary resuscitation. A rescue team arrived eight minutes later. The girl had a body temperature of sixty-six degrees, and no pulse. Her pupils were dilated and did not react to light, indicating that her brain was no longer working.
But the emergency technicians continued CPR anyway. A helicopter took her to a nearby hospital, where she was wheeled directly to an operating room. A surgical team put her on a heart-lung bypass machine. Between the transport time and the time it took to plug the inflow and outflow lines into the femoral vessels of her right leg, she had been lifeless for an hour and a half. By the two-hour mark, however, her body temperature had risen almost ten degrees, and her heart began to beat. It was her first organ to come back.
After six hours, her core temperature reached 98.6 degrees. The team tried to put her on a breathing machine, but the pond water had damaged her lungs too severely for oxygen to reach her blood. So they switched her to an artificial-lung system known as ECMO—extracorporeal membrane oxygenation. The surgeons opened her chest down the middle with a power saw and sewed lines to and from the ECMO unit into her aorta and her beating heart. The team moved the girl into intensive care, with her chest still open and covered with plastic foil. A day later, her lungs had recovered sufficiently for the team to switch her from ECMO to a mechanical ventilator and close her chest. Over the next two days, all her organs recovered except her brain. A CT scan showed global brain swelling, which is a sign of diffuse damage, but no actual dead zones. So the team drilled a hole into the girl’s skull, threaded in a probe to monitor her cerebral pressure, and kept that pressure tightly controlled by constantly adjusting her fluids and medications. For more than a week, she lay comatose. Then, slowly, she came back to life.
First, her pupils started to react to light. Next, she began to breathe on her own. And, one day, she simply awoke. Two weeks after her accident, she went home. Her right leg and left arm were partially paralyzed. Her speech was thick and slurry. But by age five, after extensive outpatient therapy, she had recovered her faculties completely. She was like any little girl again.
What makes her recovery astounding isn’t just the idea that someone could come back from two hours in a state that would once have been considered death. It’s also the idea that a group of people in an ordinary hospital could do something so enormously complex. To save this one child, scores of people had to carry out thousands of steps correctly: placing the heart-pump tubing into her without letting in air bubbles; maintaining the sterility of her lines, her open chest, the burr hole in her skull; keeping a temperamental battery of machines up and running. The degree of difficulty in any one of these steps is substantial. Then you must add the difficulties of orchestrating them in the right sequence, with nothing dropped, leaving some room for improvisation, but not too much.
Disclosure: No positions