What the Masters Would Say
An investment checklist is arguably the most powerful tool available to individual investors, and it costs nothing to create. Atul Gawande demonstrated in "The Checklist Manifesto" that checklists dramatically reduce errors in surgery, aviation, and construction -- fields where the cost of mistakes is life or death. Investing is another field where systematic process beats ad hoc decision-making, and a well-designed checklist ensures you never skip a critical step in the heat of the moment.
Charlie Munger is the most vocal advocate for checklists in investing. He has said that a simple checklist would have prevented many of the worst investment disasters in history -- Enron, WorldCom, Lehman Brothers -- because in each case, readily available information signaled danger that investors ignored because they were caught up in the excitement.
Warren Buffett's investment approach can be distilled into a checklist format: Does he understand the business? Does it have a durable competitive advantage? Is management honest and competent? Is the price attractive relative to intrinsic value? He will not buy unless all four conditions are met, and this discipline has protected him from countless mistakes over six decades.
Howard Marks emphasizes that a checklist should include "second-level thinking" questions -- questions that go beyond the obvious: What is the consensus view on this stock, and what would happen if the consensus is wrong? What is the downside if my thesis fails? Am I buying because of analysis or because of emotion?
Peter Lynch's checklist focused on practical business metrics: Can I explain what this company does in two minutes? Is it growing? Is it profitable? Is the balance sheet healthy? Is the stock reasonably priced relative to its growth rate?
Benjamin Graham's checklist was more quantitative: adequate size, strong financial condition, earnings stability, dividend record, earnings growth, moderate P/E ratio, and moderate price-to-book ratio.
Here is a comprehensive investment checklist you can adapt to your own style:
Your Action Plan
2. Financial strength: Is the debt-to-equity ratio manageable? Does the company generate positive free cash flow consistently? Can it service its debt comfortably even in a downturn?
3. Management quality: Does management allocate capital wisely? Are insiders buying or selling stock? Is executive compensation aligned with shareholder interests? Does management communicate honestly about problems as well as successes?
4. Valuation: Is the stock trading below your estimate of intrinsic value? Is the earnings yield attractive relative to bond yields? Does the PEG ratio suggest reasonable pricing relative to growth?
5. Risk assessment: What is the worst-case scenario and can you survive it? Is there a catalyst that could unlock value? What would make your thesis wrong, and how would you know?
The Bottom Line
Print your checklist and fill it out by hand for every potential investment. The physical act of writing forces careful thought and prevents the shortcuts that lead to mistakes.
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