The Checklist Manifesto (20 page)

It’s ludicrous, though, to suppose that checklists are going to
do away with the need for courage, wits, and improvisation. The work of medicine is too intricate and individual for that: good clinicians will not be able to dispense with expert audacity. Yet we should also be ready to accept the virtues of regimentation.

And it is true well beyond medicine. The opportunity is evident in many fields—and so also is the resistance. Finance offers one example. Recently, I spoke to Mohnish Pabrai, managing partner in Pabrai Investment Funds in Irvine, California. He is one of three investors I’ve recently met who have taken a page from medicine and aviation to incorporate formal checklists into their work. All three are huge investors: Pabrai runs a $500 million portfolio; Guy Spier is head of Aquamarine Capital Management in Zurich, Switzerland, a $70 million fund. The third did not want to be identified by name or to reveal the size of the fund where he is a director, but it is one of the biggest in the world and worth billions. The three consider themselves “value investors”—investors who buy shares in underrecognized, undervalued companies. They don’t time the market. They don’t buy according to some computer algorithm. They do intensive research, look for good deals, and invest for the long run. They aim to buy Coca-Cola before everyone realizes it’s going to be Coca-Cola.

Pabrai described what this involves. Over the last fifteen years, he’s made a new investment or two per quarter, and he’s found it requires in-depth investigation of ten or more prospects for each one he finally buys stock in. The ideas can bubble up from anywhere—a billboard advertisement, a newspaper article about real estate in Brazil, a mining journal he decides to pick up for some random reason. He reads broadly and looks widely. He
has his eyes open for the glint of a diamond in the dirt, of a business about to boom.

He hits upon hundreds of possibilities but most drop away after cursory examination. Every week or so, though, he spots one that starts his pulse racing. It seems surefire. He can’t believe no one else has caught onto it yet. He begins to think it could make him tens of millions of dollars if he plays it right, no, this time maybe hundreds of millions.

“You go into greed mode,” he said. Guy Spier called it “cocaine brain.” Neuroscientists have found that the prospect of making money stimulates the same primitive reward circuits in the brain that cocaine does. And that, Pabrai said, is when serious investors like himself try to become systematic. They focus on dispassionate analysis, on avoiding both irrational exuberance and panic. They pore over the company’s financial reports, investigate its liabilities and risks, examine its management team’s track record, weigh its competitors, consider the future of the market it is in—trying to gauge both the magnitude of opportunity and the margin of safety.

The patron saint of value investors is Warren Buffett, among the most successful financiers in history and one of the two richest men in the world, even after the losses he suffered in the crash of 2008. Pabrai has studied every deal Buffett and his company, Berkshire Hathaway, have made—good or bad—and read every book he could find about them. He even pledged $650,000 at a charity auction to have lunch with Buffett.

“Warren,” Pabrai said—and after a $650,000 lunch, I guess first names are in order—“Warren uses a ‘mental checklist’ process” when looking at potential investments. So that’s more or less what Pabrai did from his fund’s inception. He was disciplined. He
made sure to take his time when studying a company. The process could require weeks. And he did very well following this method—but not always, he found. He also made mistakes, some of them disastrous.

These were not mistakes merely in the sense that he lost money on his bets or missed making money on investments he’d rejected. That’s bound to happen. Risk is unavoidable in Pabrai’s line of work. No, these were mistakes in the sense that he had miscalculated the risks involved, made errors of analysis. For example, looking back, he noticed that he had repeatedly erred in determining how “leveraged” companies were—how much cash was really theirs, how much was borrowed, and how risky those debts were. The information was available; he just hadn’t looked for it carefully enough.

In large part, he believes, the mistakes happened because he wasn’t able to damp down the cocaine brain. Pabrai is a forty-five-year-old former engineer. He comes from India, where he clawed his way up its fiercely competitive educational system. Then he secured admission to Clemson University, in South Carolina, to study engineering. From there he climbed the ranks of technology companies in Chicago and California. Before going into investment, he built a successful informational technology company of his own. All this is to say he knows a thing or two about being dispassionate and avoiding the lure of instant gratification. Yet no matter how objective he tried to be about a potentially exciting investment, he said, he found his brain working against him, latching onto evidence that confirmed his initial hunch and dismissing the signs of a downside. It’s what the brain does.

“You get seduced,” he said. “You start cutting corners.”

Or, in the midst of a bear market, the opposite happens. You
go into “fear mode,” he said. You see people around you losing their bespoke shirts, and you overestimate the dangers.

He also found he made mistakes in handling complexity. A good decision requires looking at so many different features of companies in so many ways that, even without the cocaine brain, he was missing obvious patterns. His mental checklist wasn’t good enough. “I am not Warren,” he said. “I don’t have a 300 IQ.” He needed an approach that could work for someone with an ordinary IQ. So he devised a written checklist.

Apparently, Buffett himself could have used one. Pabrai noticed that even he made certain repeated mistakes. “That’s when I knew he wasn’t really using a checklist,” Pabrai said.

So Pabrai made a list of mistakes he’d seen—ones Buffett and other investors had made as well as his own. It soon contained dozens of different mistakes, he said. Then, to help him guard against them, he devised a matching list of checks—about seventy in all. One, for example, came from a Berkshire Hathaway mistake he’d studied involving the company’s purchase in early 2000 of Cort Furniture, a Virginia-based rental furniture business. Over the previous ten years, Cort’s business and profits had climbed impressively. Charles Munger, Buffett’s longtime investment partner, believed Cort was riding a fundamental shift in the American economy. The business environment had become more and more volatile and companies therefore needed to grow and shrink more rapidly than ever before. As a result, they were increasingly apt to lease office space rather than buy it—and, Munger noticed, to lease the furniture, too. Cort was in a perfect position to benefit. Everything else about the company was measuring up—it had solid financials, great management, and so on. So Munger bought. But buying was an error. He had missed the
fact that the three previous years of earnings had been driven entirely by the dot-com boom of the late nineties. Cort was leasing furniture to hundreds of start-up companies that suddenly stopped paying their bills and evaporated when the boom collapsed.

“Munger and Buffett saw the dot-com bubble a mile away,” Pabrai said. “These guys were completely clear.” But they missed how dependent Cort was on it. Munger later called his purchase “a macroeconomic mistake.”

“Cort’s earning power basically went from substantial to zero for a while,” he confessed to his shareholders.

So Pabrai added the following checkpoint to his list: when analyzing a company, stop and confirm that you’ve asked yourself whether the revenues might be overstated or understated due to boom or bust conditions.

Like him, the anonymous investor I spoke to—I’ll call him Cook—made a checklist. But he was even more methodical: he enumerated the errors known to occur at any point in the investment process—during the research phase, during decision making, during execution of the decision, and even in the period after making an investment when one should be monitoring for problems. He then designed detailed checklists to avoid the errors, complete with clearly identified pause points at which he and his investment team would run through the items.

He has a Day Three Checklist, for example, which he and his team review at the end of the third day of considering an investment. By that point, the checklist says, they should confirm that they have gone over the prospect’s key financial statements for the previous ten years, including checking for specific items in each statement and possible patterns across the statements.

“It’s easy to hide in a statement. It’s hard to hide between statements,” Cook said.

One check, for example, requires the members of the team to verify that they’ve read the footnotes on the cash flow statements. Another has them confirm they’ve reviewed the statement of key management risks. A third asks them to make sure they’ve looked to see whether cash flow and costs match the reported revenue growth.

“This is basic basic basic,” he said. “Just look! You’d be amazed by how often people don’t do it.” Consider the Enron debacle, he said. “People could have figured out it was a disaster entirely from the financial statements.”

He told me about one investment he looked at that seemed a huge winner. The cocaine brain was screaming. It turned out, however, that the company’s senior officers, who’d been selling prospective investors on how great their business was, had quietly sold every share they owned. The company was about to tank and buyers jumping aboard had no idea. But Cook had put a check on his three-day list that ensured his team had reviewed the fine print of the company’s mandatory stock disclosures, and he discovered the secret. Forty-nine times out of fifty, he said, there’s nothing to be found. “But then there is.”

The checklist doesn’t tell him what to do, he explained. It is not a formula. But the checklist helps him be as smart as possible every step of the way, ensuring that he’s got the critical information he needs when he needs it, that he’s systematic about decision making, that he’s talked to everyone he should. With a good checklist in hand, he was convinced he and his partners could make decisions as well as human beings are able. And as a result, he was also convinced they could reliably beat the market.

I asked him whether he wasn’t fooling himself.

“Maybe,” he said. But he put it in surgical terms for me. “When surgeons make sure to wash their hands or to talk to everyone on the team”—he’d seen the surgery checklist—“they improve their outcomes with no increase in skill. That’s what we are doing when we use the checklist.”

Cook would not discuss precise results—his fund does not disclose its earnings publicly—but he said he had already seen the checklist deliver better outcomes for him. He had put the checklist process in place at the start of 2008 and, at a minimum, it appeared that he had been able to ride out the subsequent economic collapse without disaster. Others say his fund has done far better than that, outperforming its peers. How much of any success can be directly credited to the checklist is not clear—after all, he’s used it just two years so far. What Cook says is certain, however, was that in a period of enormous volatility the checklist gave his team at least one additional and unexpected edge over others: efficiency.

When he first introduced the checklist, he assumed it would slow his team down, increasing the time and work required for their investment decisions. He was prepared to pay that price. The benefits of making fewer mistakes seemed obvious. And in fact, using the checklist did increase the up-front work time. But to his surprise, he found they were able to evaluate many more investments in far less time overall.

Before the checklist, Cook said, it sometimes took weeks and multiple meetings to sort out how seriously they should consider a candidate investment—whether they should drop it or pursue a more in-depth investigation. The process was open-ended and haphazard, and when people put a month into researching an
investment, they tended to get, well, invested. After the checklist, though, he and his team found that they could consistently sort out by the three-day check which prospects really deserved further consideration and which ones didn’t. “The process was more thorough but faster,” he said. “It was one hit, and we could move on.”

Pabrai and Spier, the Zurich investor, found the same phenomenon. Spier used to employ an investment analyst. But “I didn’t need him anymore,” he said. Pabrai had been working with a checklist for about a year. His fund was up more than 100 percent since then. This could not possibly be attributed to just the checklist. With the checklist in place, however, he observed that he could move through investment decisions far faster and more methodically. As the markets plunged through late 2008 and stockholders dumped shares in panic, there were numerous deals to be had. And in a single quarter he was able to investigate more than a hundred companies and add ten to his fund’s portfolios. Without the checklist, Pabrai said, he could not have gotten through a fraction of the analytic work or have had the confidence to rely on it. A year later, his investments were up more than 160 percent on average. He’d made no mistakes at all.

What makes these investors’ experiences striking to me is not merely their evidence that checklists might work as well in finance as they do in medicine. It’s that here, too, they have found takers slow to come. In the money business, everyone looks for an edge. If someone is doing well, people pounce like starved hyenas to find out how. Almost every idea for making even slightly more money—investing in Internet companies, buying tranches of sliced-up mortgages, whatever—gets sucked up by the giant maw almost instantly. Every idea, that is, except one: checklists.