Lessen your emotions

The case for an investment checklist

Published on:
February 2, 2020
Reading Time: 8 Minutes.
Written on:

About The Author

Noam Ganel, CFA is the founder of Pen&Paper, a value-oriented, contrary-minded journal of the financial markets. Noam worked as a Vice President in Capital Markets at Silvergate (publicly traded on NYSE under SI since Nov-2019.) At SI, which he joined in 2010, Noam was responsible for advisory services to family offices,  private companies, and financial advisors.

Investment checklist is a set of questions you go over before making an investing decision. The checklist lessens the emotional aspect of investing by forcing you to think before you act. It results in a better decision making process.

Strangely, academia doesn't talk about the value of checklists. It is also strange that in investment circles, hardly anyone mentions the checklist. Google the term' investment checklist,' and you will only find vague, general, abstract thoughts.

I never heard of the investment checklist while in business school. I even studied for the Chartered Financial Analyst (CFA) designation for five years, and not once did I come across the phrase.

So this essay attempts to correct this missing information. My goal is that you will understand why the investment checklist is essential and that you will have a list of over 50 checklist items to use in your research.

As I wrote in The Hats The Investor Must Wear, knowing which stocks to avoid is the first step in investment research. And checklists help to achieve that first step.

How checklists became popular

In Chapter 11 of The Education of Value Investor, Guy Spier writes:

"Even with a well-constructed environment and a robust set of investment rules, we are still going to mess up. The brain is simply not designed to work with meticulous logic thorough all of the possible outcomes of our investment decisions. The complexity of the business world, combined with our irrationality in the face of money-related issues, guarantees that we'll make plenty of dumb mistakes...there is one other investment tool that is invaluable that it merits a chapter it is own: a checklist."

Spier mentions that it was Mohnsih Pabrai that explained to him how valuable was the checklist. And that revelation came to Pabrai after reading Atul Gawande's description of how pilots use checklists. He writes:

"…they came up with an ingeniously simple approach: they created a pilot's checklist, with step-by-step checks for takeoff, flight, landing, and taxiing. Its mere existence indicated how far aeronautics had advanced. In the early years of flight, getting an aircraft into the air might have been nerve-racking, but it was hardly complex. Using a checklist for takeoff would no more have occurred to a pilot than to a driver backing a car out of the garage."

Pabrai [1] followed the technique. And by the second edition of The Checklist Manifesto, Gawande mentioned how Pabrai was using checklists in investment decisions.

An example of a checklist

I keep a checklist in a CODA document [2]. My checklist evolves around items such as balance sheet, income statement, risks, management, product, capital allocation, credit, product, competitive landscape, investment thesis, valuation, and corporate governance.

For example, on liabilities, the following checklist items appear:

-What are the major debt covenants, and is the company meeting those minimum debt requirements?
-What is the company's management experience with capital markets?   
-Is the company placing debt at market terms, or are they forced to raise debt at unfavorable conditions?
-Is there balloon payment over the next five years?
-Does the company have the ability to issue debt, if needed?
-What assets will be used as collateral?
-Is the debt payment floating- or fixed-payments?  
-Has the company's credit ratios improved?
-Does cash flow from operations service the debt payments?
-What is the fair value of the debt?
-What is the peer group's leverage ratios?
-What are the liquidity and capital resources over the years five years?
-What are the debt rating agencies saying?

The uses and drawbacks of investment checklists

"If you want to improve the quality of the decision," said Daniel Kahneman in an interview to Farnam Street, "Use algorithms, whenever you can. If you can replace judgments by rules and algorithms, they'll do better. Indeed, when we write an investment checklist, we reduce the emotional aspect of investing.

Another benefit to the investment checklist is it serves as a starting point.  You don't need to invent the wheel each time you research a stock, just follow the lessons of the past. (More on that in the section below.)

The checklist also grounds you. Many times in the past, I felt a high conviction about a company. And just as I was about to buy the stock, I went over the checklist, only to realize that either (1) I missed out on crucial points, or (2) the position didn't meet the criteria I had set for myself.

But there are two drawbacks to the investment checklist, too. First, the checklist gives a false sense of security. As if buying a stock is akin to boarding a plane; that all we need is a checklist, and we will safely reach our destination.

But the truth is that there are risks that we cannot prepare for. Investing is placing a bet on human psychology just as it is on the fundamentals of the business. And we can't predict human behavior, let alone all the factors that will influence the price of a stock.

Investing is placing a bet on human psychology.

This reminds me of how the Oracle from Omaha was baffled by David Sokol's irrational behavior. In the 2011 Berkshire annual meeting, Buffett said that Sokol had given away to a junior partner four times the amount Sokol purchased Lubrizol. In Buffett's words:  

"I witnessed Dave voluntarily, transfer over 12.5 million dollars - getting no fanfare, no credit whatsoever to his junior partner...what makes it extraordinary is that $3 million, you know, ten or so years later, would have led the kind of troubles that it's led to."

Sokol's forerunning Lubrizol was unpredictable and made no sense. Munger summed it best:

"I think it's generally a mistake to assume that rationality is going to be perfect, even in very able people."

The second drawback to the checklist is that the more you rely on it, the less likely you are to follow your conviction. It is almost like the paradox in game theory that shows that no matter how fast the wolf is, it will not catch up with the turtle if both objects are stationary [3].

Similarly, in my view, there is a point in time where the investment checklist causes more harm than good. It becomes an obstacle. Or an excuse to sit idly. And many investing mistakes are mistakes of omission.

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A list of investment checklists by great investors  

Trying to think like great investors is an excellent exercise. One of my favorite past time is to ask what great investors would ask me before I buy a stock.

Having this imaginary investment committee is one of the best ways to stretch investing skills. So I gathered a list of the top questions each great investor would ask:

What Phillip Fisher would ask

1. Does the company have products or services with sufficient market potential to make possible a sizable increase in sales for at least several years?
2. Does the management have a determination to continue to develop products or processes that will still further increase total sales potentials when growth potentials of currently attractive product lines have largely been exploited?
3. How effective are the company's research and development efforts in relation to its size?
4. Does the company have an above-average sales organization?
5. What is the company doing to maintain or improve profit margins?
6. Does the company have the depth to its management?
7. Are other aspects of the business somewhat peculiar to the industry involved, which will give the investor important clues as to how outstanding the company may be in relation to its competition?
8. Does the company have a short-range or long-range outlook regarding profits?
9. In the foreseeable future, will the growth of the company require sufficient equity financing so that the larger number of shares then outstanding will largely cancel the existing stockholder's benefit from this anticipated growth?
10. Does the company have management of unquestionable integrity?


What Walter Schloss would ask

1. What is the value of the company? You are buying shares in a business.
2. Is the value you get worth the price you pay?
3. Are you comfortable holding- and following the stock for five- to ten-years?
4. Is this company using debt to finance its operations? If so, why?
5. Why are you buying the stock?
6. What are the assets you are buying?
7. Are you willing to hold the conviction for a long time? More than two years?
8. What is the true book value of the company after adjustments?
9. Is the price low relative to a few years back?
10. Don't forget to look at the value of the stock before selling.

What Charlie Tian of GuruFocus would ask

1. Do you understand the business?  
2. What is the economic moat that protects the company so it can sell the same or similar product five or ten years from today?  
3. Is this a fast-changing industry?
4. Does the company have a diversified customer base?
5. Is this an asset-light business?
6. Is it a cyclical business?
7. Does the company still have room to grow?
8. Has the company been consistently profitable over the past ten years, through good time and bad?
9. Does the company have a stable double-digit operating margin?
10. Does the company have a higher margin than competitors?


What Michael Shearn would ask

1. Do you want to spend a lot of time learning about this business?
2. Who is the core customer of the business?
3. Does the business have a sustainable competitive advantage?
4. What are the fundamentals of the business?
5. Are the accounting standards that management uses conservative or liberal?
6. What type of manager is leading the company?
7. Does the CEO manage the business to benefit all stakeholders?
8. Does the CEO love the money or the business?
9. Does the business grow through mergers and acquisitions, or does it grow organically?
10. Have past acquisitions been successful?

What Peter Lynch would ask

1. Is there a raider in the wings to help shareholders reel the benefits of the assets? (for asset plays)  
2. Are costs being cut?  (for turnover situations)
3. Did the company duplicate its success in more than one city or town, to prove that expansion will work (for fast-growers)
4. What is the company's long-term growth rate, and has it has kept up the same momentum in recent years? (for stalwarts)
5. What percentage of earnings are being paid out as dividends? (for slow -growers)
6. What is the institutional ownership? (the lower, the better)
7. Is the p/e ratio high or low for the company and for similar companies in the same industry?
8. Is the product that's supposed to enrich the company is a major part of the company's business?  
10. How is the company supposed to turn around? (for turnaround situations)

Conclusion & further resources

Before I leave you to write down checklists of your own, I want to emphasize three points. First, checklist items are evolving in nature. What used to be important in the past may be outdated in today's markets.

Second, you may need a different set of checklist items for different scenarios. A specific checklist item may apply to a particular industry or company size, but irrelevant to another. Remember that checklists aren't there to remove the thinking from the investment process, the checklist is there to support it.

Third, make the checklist specific to your experience; to your criteria of investing.  

If you are interested in reading more about checklists, the following resources are a good starting point. Written by Atul Gawande, The Checklist Manifesto provides an excellent overview of industries such as the medical profession use checklists.

More specific to investing, I suggest The Investment Checklist by Michael Shearn. In that book, he provides over 50 checklist items. The Manual of Ideas, written by John Mihaljevic, breaks down the questions you want to ask, depending on your acquisition criteria. Specifically: when you buy Graham-style bargains when you look for hidden assets in a balance sheet, when you look at management, and so so forth.  

FOOTNOTES: [1] Not to be taken for granted that an investment manager is reading the New Yorker. [2] I use CODA and not a regular word document, because CODA allows dividing a page into sections. [3] The Zenos paradox.
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