When we look to make an investment, the greed part of the brain is turned on. A checklist is like a circuit breaker that helps prevent the brain from being able to flip that switch.
Looking at many successful fund managers, one thing they have in common would be this ‘checklist’. Be it superinvestors or even local value fund managers, they would have some form of checklist when assess the quality of the company. Is the company buying back shares? Is the company in a dying industry? Yeoman 3-Rights etc. Checklists aren’t proven to be only successful with investing but in many other fields where mistakes can be easily made due to human error. Pabrai made an analogy to pilots where they would go through a detailed checklist before flying. Using this checklist, it helps one prevent missing a certain procedure that could actually result in a high failure rate.
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Pabrai did not publish his checklist, stating that it would be more beneficial for individuals to develop their own. This is because everyone have different experiences and it should be left to them to figure out what checks should be in their own checklist. Through mistakes over the years, we would realise what are some of the certain checks that have to be in place to prevent it from happening again.
In today’s article I would just be sharing some of the main checks I believe should be placed on everyone’s investment checklist manifesto.
- Debt-to-Equity. Personally, I prefer companies that are cash rich with little or no debt. I would agree that companies with certain amounts of debt would be preferable such as in the case of Apple. However, how much is sufficient? I believe the sweet spot would be less than 25%. To quote Buffett, “Huge debt, we were told, would cause operating managers to focus their efforts as never before, much as a dagger mounted on the steering wheel of a car could be expected to make its driver proceed with intensified care. We’ll acknowledge that such an attention-getter would produce a very alert driver. But another certain consequence would be a deadly – and unnecessary – accident if the car hit even the tiniest pothole or sliver of ice. The roads of business are riddled with potholes; a plan that requires dodging them all is a plan for disaster.”
- Is management constantly raising capital through rights issues. One thing I hate would be companies that keeps raising capital through rights issues. This would indicate underlying problems within the company – a sinking ship. Though we have the choice of not subscribing to the rights issue, it would just mean a dilution of our stake in the company.
- Related Party Transactions. This would stem from my encounters of S-Chips. One would notice the company dealing mainly with related companies. This raises various potential red flags to me and looking at enough research cases, more often than not companies with high related party transactions are fraudulent in nature.
- Free Cash Flow. Questions should be asked such as is cash flow overstated because of an unsustainable recent boom? Getting a normalised free cash flow over a 5-year and asking yourself if you believe the company would perform better than or equal to this level going forward.
- Speculation or Investment? Many a times we see prices falling and we think of allocating some capital there thinking that it would be a good purchase (e.g. recent downtrend in oil producers). However, we have to question ourselves if we are merely speculating or making a sound and logical decision. Are we flouting any of our rules in our rule book? Such as the IPO of Shake Shack or Alibaba, based on gut feelings I know the share price would probably keep going up despite it being priced quite highly and it being an IPO. Knowing that there is money to be made, should I then invest in it? How I view it would be like playing poker, ensuring that I am discipline when calling and not just betting on luck. Essentially, I may miss various opportunities, however, at least I limit my downside.
That said, the list is by no means exhaustive but only something to get individuals started and thinking. With the checklist, there are no right or wrong answers as only you understand yourself best. Perhaps you know that you tend to make investment mistakes if not clearly thought through. Hence, one check could be if you have pondered over the decision over X-days before deciding to buy.