Pope Brar's checklist for investing looks like a powerful tool for reducing mistakes. In it, he extensively covers a long checklist, pointing out places where people often make mistakes. We cover the entire list here, including an introduction that lays out how to use the checklist, as well as putting it in a historical context. The full text is below:
"There are many mistakes that we make as investors. Even the greatest investors have made simple mistakes. Our brains are designed to take shortcuts and arrive at answers quickly. In a financial crisis, our brains are wired to sell when it may be wise to hold or buy more. How does one rationalize the investment decision making and learn from the greatest investors in the world? It’s simple: one analyzes their mistakes and develops an extensive checklist.
The checklist has also been a very powerful tool in hospitals and operating rooms where precision is necessary. After the B-17 bomber crash early in the 20th century, The Boeing Company (NYSE:BA)’s survival was in question. Shortly after, a checklist was born. There have been zero accidents since and the US government ordered 13,000 more B-17 bombers.
I went through annual letters of Warren Buffett and read countless literature on great investors such as Seth Klarman, Peter Lynch, Bruce Berkowitz, Michael Burry, and others. The final result is an extensive 90+ item checklist that one can use to reduce investment mistakes. The checklist attempts to stress test or “kill” the company’s business model.
The checklist focuses on four pillars of our margin of safety analysis (SAVR):
- Sustainability of the Business Model
- Accountability of the management
- Value of the investment
- Risk factors (i.e. business/emotional risk and leverage)
While no business will pass the checklist with a perfect mark, the goal is to alert the investor to the potential pitfalls. The checklist should take less than an hour to complete. It analyzes each candidate company by determining the answers to key questions in each of the major pillars discussed above. Here are some examples:
The checklist verifies management accountability in a number of ways, for example, by listing whether there have been any “related party transactions,” i.e., to see if management has been engaged in significant self-rewarding behavior. If so, that would be a signal that management may not be fully operating for the benefit of all shareholders.
Another check on accountability is whether or not the company has achieved the goals or objectives that the company’s CEO pronounced in previous annual letters to shareholders. If not, the shortfalls should be explained, e.g., whether it was because of worse-than-expected economic conditions, operational problems, or for any other reasons. Management needs to explain why their plans, goals and strategies have not been successful. If they have been successful, of course, that is a plus for making the investment.
Another signal to look for in terms of management accountability is whether management is appropriately aligned with the interests of the shareholders, for example, by holding a “reasonable” percentage of the outstanding shares.
Is There Too Much Leverage?
Excessive leverage can ruin a company, pushing it into bankruptcy for a variety of reasons, for example, if the business environment turns bad or if a competitive new product comes onto the market, substantially reducing demand and sales for the company’s products. At the very least, excessive borrowing can lead to substantially reduced earnings during an economic downturn.
Therefore, the checklist includes questions about the company’s level of debt. For example, does the company have sufficient liquid assets minus liabilities to qualify for a potential “liquidity mismatch”? Sometimes the liquid value of the company’s assets is more than the liabilities but does not show on the balance sheet. For example, is value of the company’s real estate listed at cost? Important to check as real estate is likely to appreciate over time. It also considers whether the company’s earnings before interest and taxes are sufficient to cover the interest expense for the next two years. If not, that’s a negative signal for the company’s long-term health.
What Is the Company’s Intrinsic Value?
We use the checklist questions on valuation to see whether or not the company is over- or undervalued. The checklist considers such questions as, have I checked for hidden value in properties, and/or historic book value? Have I considered the potential over-valuation of the underlying currency behind the stock? And, am I thinking with an “owner’s hat,” i.e., would I personally spend my own funds to buy the company given what I have learned about the business quality and value? If I can answer yes to that question, it is obviously a candidate for inclusion in the portfolio.
The Problem of Emotional Risk
Finally, the checklist considers the risk of whether we have become attached to the idea of owning shares of a particular company, despite other aspects that would disqualify its inclusion in our portfolio. For example, it considers whether past successes of the company might be swaying our judgment about its future, even though other aspects of the checklist may point to warnings of overvaluation or signs of a potential slowdown in the growth of the company.
The SAVR Checklist for Analyzing a Business
This 90+ item checklist is based on mistakes of great investors such as Warren Buffett, Seth Klarman, Peter Lynch, and more. It attempts to stress test or “kill” the company’s business model. The checklist focuses on four pillars of our investment analysis: 1. Sustainability of the Business Model 2. Accountability of the management 3. Value of the investment 4. Risk factors (i.e. Business/Emotional Risk and Leverage). While no business will pass the checklist with a perfect mark, the goal is to show the pitfalls and potentially avoid permanent loss of capital.
Sustainability of the Business
1. Do I understand the business? (Can I draw its product or service with a pen?)
2. Have I tried the company's products? If so, do they add any personal or societal value?
3. What is the industry structure? (i.e. Consolidated or numerous players)
4. What are the two-four most important factors that drive the business? (e.g. Corn price for agriculture companies)
5. What are the operating metrics that I need to follow? (e.g. Loan quality and management at banks, corn price for fertilizers, etc.)
6. Have I checked for the progression of historic margins? (An alert, if the long term trend is negative)
7. What is its competitive advantage "niche"? (i.e. Low cost producer, network effect, innovation, distribution, economies of scale, brands, patents, switching costs)
8. Have I monitored the market for entrance of new competitors?
9. Is the company part of a cartel? Who is the low cost leader if the cartel breaks down? (e.g. Potash cartel breakdown 2013)
10. Does the business reflect a fading trend? (e.g. Large mall based retailers)
11. Can the product be made more cheaply by a competitor in another country?
12. Where will the company be in 10 years?
13. What is the company's source of growth?
14. What was the composition of earnings’ growth over the past five years? (i.e. Organic, buy-backs, M&A).
15. Is the leading profitability factor at a high without any fundamental reason or simply due to speculation? (e.g. This question is heavily applicable to commodity producers. Corn price at highs in 2008 was an alert to sell Ag stocks before they plunged).
16. What headwinds do the earnings face?
17. If the company is enjoying regional success, can it be extended nationally?
18. How will high unemployment rates and economic recession hurt the business?
19. Have I considered the macro factors despite attractive micro characteristics of the company? (e.g. do stocks in a sector “look inexpensive” despite upcoming troubles? Don’t be fooled, PE’s of cyclical companies are often lowest before the cycle and the earnings start to decline).
20. Does the business benefit or hurt society? (e.g. Cigarettes faced legal headwinds in the past since they do not benefit society).
21. Have I considered potential overvaluation of underlying currency behind the stock?
22. Are inventory levels of finished goods increasing in an abnormal manner vs. economic conditions? Is inventory build-up occurring faster than sales? Watch for inventory write-downs!
23. Is the company operating in a dangerous geographic area with corporate governance and/or political issues? (Country exposure: check for credit growth, 90-day non-performing loans; watch real estate prices vs. historically normalized levels).
Accountability of the Management
Check proxy statements for details on insider engagement
25. Does the CEO have a good track record (M&A and operational)? Check past history.
26. Has the management fulfilled past promises? Check annual letters.
27. Do the insiders own a significant portion of shares in the business?
28. How has the management allocated capital in the past? Have they announced changes to their capital allocation strategy?
29. What is the tone of the management in corporate media? Do they appear to be over confident? If they can’t properly manage expectations, it’s likely they can’t properly manage the business.
30. Are there frequent write-downs? If not, have I added back one time charges?
31. Is the management overcompensated vs. their employees? Is compensation in-line with earnings growth?
32. Have I checked for 'related party transactions' to see if management self-rewards?
33. Is there excessive options rewarding