Atul Gawande is a world-renowned surgeon who wrote a best-selling book about checklists. Yes, simple checklists. Sounds boring right?
Well, in the Checklist Manifesto, he tells a story about the rock-band Van Halen. In the early 80’s, the band was uber-famous, routinely playing for sold-out crowds. But setting up all the equipment for these big shows wasn’t easy.
The band would naturally outsource this work to staging companies. When crafting these contracts, lead singer David Lee Roth, would sneak in an odd request. The stipulation was that he required a bowl of M&M’s backstage, but the brown ones MUST be removed.
When the media caught wind of this, they chalked it up to a rock-star just being ridiculous. But Roth had his reasons.
The concert stage had 850 lights, too many cords to count and cost tens of thousands of dollars. It wasn’t easy to set up. Therefore, Roth figured that by putting an odd request in the contract, it would be a test to see how thorough the staging company had been. If he went backstage and saw brown M&M’s he would double-check everything and surely find problems.
It wasn’t superstar ego, rather it was the power of a thorough checklist.
More seriously, Gawande tells a story about a doctor named Peter Pronovost who tested this checklist theory in 2001 at John Hopkins Hospital.
After almost losing a patient to a line infection (catheter-related), Pronovost scribbled these five checklist items on a blank sheet of paper and asked nurses to keep the M.D.'s accountable:
Doctors must:
(1) wash their hands with soap
(2) clean the patient’s skin with chlorhexidine antiseptic
(3) put sterile drapes over the entire patient
(4) wear a sterile mask, hat, gown, and gloves
(5) put a sterile dressing over the catheter site once the line is in.
The results were staggering.
Gawande writes,
"Only two line infections occurred during the entire period. They calculated that, in this one hospital, the checklist had prevented forty-three infections and eight deaths, and saved two million dollars in costs."
Checklists are helpful in investing as well. They give us direction and stop us from making mistakes.
Here is the full checklist I use for making investment decisions. Below, I will expand on each section.
DISQUALIFIERS
1. Am I interested in learning more about the company?
IMPORTANT
2. Is it in my circle of competence? (do I know the business model and the industry/2 or 3 very important metrics or unit economics?)
3. Clear business thesis (why do I think this company will be a good stock?)
MOAT
4. What is that “it” factor that makes it better than all the other competitors? (leader, business momentum, best management, bad competitors)
5. Have you looked at the innovative decision tree?
6. How do you think about resilience and optionality?
7. What is the value proposition? How much value are they providing?
8. How is the culture of the company? How do they treat employees? Glassdoor ratings?
MANAGEMENT
9. Management’s share in the business/smart backing?
10. Founder-led?
11. Is the company innovating? Long term view? Recent new products?
FINANCIALS
12. Revenue growth, margin expansion, operating cash flow (FCF margins), ROIC
13. Capital structure, too much debt? Diluting a lot?
14. Total addressable market, how well do you know the industry?
BIASES
15. Do I like this just because I have spent a lot of time researching it?
16. Am I letting price action color my vision?
17. Is this the absolute best choice I can make or am I di-worsifying?
18. Am I seeking to find reasons to like this company rather than just letting the facts speak?
VALUATION
19. How confident am I in the assumptions to get a 5 year 20% CAGR?
ALLOCATION
20. What is my gut-level conviction and the upside potential?
21. Pre-mortem: if this turns out to be a bad investment, what will be the reasons?
Granted, this checklist isn't fool-proof. You actually need context to know good vs. bad. For instance, is revenue growth of 15% good or bad?
Well, it's awesome if it has been accelerating from 2% to 5% and now all the way to 15%. But it might not be so great if it decelerated all of a sudden from 50%.
This is also why we use reverse DCFs and earnings models rather than simple multiples. Reverse DCFs you to test the reasonableness of the assumptions. If we are looking at two companies in the same space, does it make sense to compare multiples and make a decision based on which one has the lower PE?
After all, each company is likely very different. Different culture, different founder, different growth rate, different marketing and distribution strategy.
That's why valuation is at the end of the checklist as well. That wasn't by accident.
If we seek to own business for a long time, the valuation is rarely cheap. If it is too cheap, the business is probably bad or it has hit a road-bump where an eventual turnaround is unclear.
So if we have confidence around the business, the moat, the management, the financials, and our biases, valuation is the cherry on top.
Of course, there is an upper limit on what makes sense to pay, but it makes more sense to us to look at which variables are involved rather than a simple multiple comparison, even for companies in the same industry.
If we do look at multiples, it almost always includes a growth component. For the software companies we look at, our favorite metric is (gross profit growth relative to enterprise value divided by forward sales). This way we don't look at the EV/sales ratio in isolation.
Let's dig into the order of the checklist real quick.
DISQUALIFIER
1) We start off with the disqualifier: Am I interested in learning more about the company?
If we simply couldn't care less about this business and would be extremely bored by looking at it, we'll pass. This is rare because there are so many businesses that seem boring but once you start peeling back the layers, they become fascinating.
Even a boring business like supplying after-market parts for airplanes is interesting. Heico, a 5-bagger in the last 5 years, is a testament to that.
The disqualifier also gets into moral issues. Personally, I will never invest in a price-gouging drug company or the tobacco industry. Other investors are free to make their own decisions, but when there are thousands of great companies out there, I would rather have my money behind companies that are positive for all parties involved (customers, employees, shareholders, and suppliers).
IMPORTANT
Moving on, the "important section" can be thought of as a secondary set of disqualifiers.
2) Is the company in my circle of competence?
If the company is outside the circle, we have a choice to make: either, dig in and learn a whole new industry or just pass.
It is much easier to pass so it has to be a very promising idea to choose to dig in. The areas where it makes sense to dig in usually involve big secular growth trends (software, digitization, food delivery, pet care, etc.)
One trick that is helpful for a lot of investors to think about is going deep in one area.
If you know one industry like the back of your hand, I mean like, REALLY know it, when you come across a new industry, you will subconsciously compare your depth of knowledge to the industry you know really well. This way you have a benchmark, or at least a ballpark, where you need to get up to speed rather than fooling yourself by thinking you know a lot about a new industry.
3) Further, we need a clear business thesis.
If you have to really dig for a thesis, it's probably too complicated. What this does is disqualifies a lot of companies that are valuation plays. The word "business" is not an accident. If our thesis is that a company is cheap then we are implicitly saying that we think a turnaround is evident or we are relying on multiple expansion. Turnarounds are hard to get right so I choose to sit on the sidelines for most of those, and betting on multiple expansion is speculating in my opinion.
Therefore, a solid business thesis is necessary. Here are a few examples.
- Disney is leveraging its second-to-none content to create a streaming service by which it can then increase the average revenue per Disney fan.
- Google is the world's leading search engine with multiple assets that could provide incredible optionality (YouTube, Waymo, Moonshots).
- Vail Resorts has property in places that are amazingly valuable. This allows them enviable pricing power and now it has expanded into offerings that reduce the seasonality of the business.
A clear thesis doesn't need to be long. But notice that there is an included element of track-ability. What I mean is that the thesis can be tied to metrics so that you can know when your thesis is broken.
For instance, if Disney doesn't see any uplift in revenues from its other business segments outside of DTC, then maybe the focus should just be on Disney+. This likely wouldn't be a broken thesis but an opportunity for adjusting it.
Or if Vail Resorts starts seeing softness in pricing power that could indicate that people are simply not willing to spend $200/day (or whatever upper limit) on skiing. Maybe other smaller resorts could fill in that void.
MOAT
Moving onto the "moat" section, it really clarifies the type of company we like looking for and that is leaders.
4) What is the “it” factor that makes the company better than all the other competitors?
We aren't so interested in spaces where competition reigns supreme like airlines or grocery stores. We'd rather invest in businesses that have a lock on their market or are at least out in front. This usually doesn't show up in traditional market share statistics though. Our favorite type of company is one that is disrupting a big space but it is out in front of other disruptors.
This is for two reasons.
a) The market typically has a hard time valuing these companies and
b) People don't think they have a moat because they are smaller.
However, moat can take many forms. For example, switching costs are undervalued. When we talked to Sean Stannard-Stockton of Ensemble Capital he mentioned how sticky payroll software was because of switching costs. Imagine you're an HR rep and you have a new company come to you, trying to undercut your current provider. Is a few thousand dollars of cost savings (to your company, not you) going to make it worth the risk of missing people's payment schedules? Unlikely.
5) Have you looked at the innovative decision tree?
If you haven't read our post on Discontinuous Disruption, it would be helpful to do that.
The basic premise is that there are three main types of innovation:
1. Sustaining
Sustaining innovations are when the same products are made better on common consumer preference vectors (price, capabilities, form factor, etc.). A good example is when Apple releases a new iPhone and it has a higher definition screen and more battery life. These improvements are necessary and a really good sustaining innovation can get you far. The new iPhone 11 now has three cameras, which is awesome for people who have been wanting top-notch picture quality.
2. Discontinuous
Discontinuous innovations completely change how something is done, typically driven by a platform shift (on-premise to cloud, desktop to mobile, etc.). The shift in platform enables a better customer value proposition on at least one consumer preference vector, which is usually convenience. If it was price, then it would likely fall into the next category.
3. Disruptive
Disruption is when a company either comes in at the low-end of a market or it creates a new market. Contrary to popular usage, disruption does not refer to technology. It is a market orientation that buys time without fierce competition from incumbents.
Then, using this framework, we can check it against this decision tree to see where it fits. We also take a long time to research competitors using this tree.
6) How do you think about antifragility and optionality?
Antifragility is the ability to get stronger through adversity. The concept is from Nassib Taleb and it just forces you to think about the business downside risk. In other words, how adaptable is the company?
Further, optionality is more about the business upside. What could go right and what would be the magnitude of that?
7) How much value is the company providing?
Capitalism works. Usually, people make money based on how much value they provide. Sure, for a while producers can have a surplus but a company was able to get to that point because they provided more value initially.
For example, credit card networks have incredible margins, some may call it a producer's surplus. Yet, they were able to get there because they did the tough, upfront work of signing on millions of merchants and issuing banks.
No company gets big by having a worse product with worse marketing. It just doesn't work that way. The more value a company can provide, the bigger it will get.
8) What is the company culture like?
This one can be hard to discern. Some people may be asking, why isn't this checklist item under the "management" section? Well, this is why it is last in the "moat" category and the main reason is because culture outlives management.
If the founder is still a part of the company (something we really like), the culture probably takes after her. However, culture is its own thing. When a company has thousands of employees, they aren't going to be carbon-copies of the founder.
To ferret out the true culture, we like reading through Glassdoor reviews and talking to current employees. But one caveat on this one, don't give too much weight to one opinion on this one. Some employees have had bad experiences or didn't get their "justified" salary so they are butt-hurt. Take the reviews and conversations with a grain of salt and integrate them into everything else you know about the company.
MANAGEMENT
9) The first question for assessing management is: what does the skin-in-the-game look like?
If management sounds extremely bullish on their company, but they barely own any stock, that is questionable. Put your money where your mouth is, right?
It comes back to incentives. As Charlie Munger says,
"I think I've been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I've underestimated it."
10) Ideally, we also love to invest in founder-leaders.
A founder's mentality is just different. This company is their baby. They've spent years dreaming about it, countless sleepless nights thinking about improving their offering, and, usually, their entire reputation and livelihood is riding on the success of the company.
Would you rather have that or a career CEO who needs to learn the business?
While there are certainly exceptions, a founder/CEO is our ideal situation.
11) Third, is the company innovating?
Innovation starts with the leadership team. If it has laid a foundation of innovation, it will be clear. Ever seen an Amazon earnings press release? The "Highlights" section takes up an incredible amount of lines.
If the company never announces new products or they don't seem to be iterating to make the user experience better, it is likely stagnating. Even if these companies are the current leaders, the stagnators (not a word) of today are the laggards of tomorrow.
FINANCIALS
12) The first section is an income and cash flow financial check-up.
Just like a routine physical, you can tell your doctor you're healthy, but unless she actually does the work to find out, you can't be sure. It's kind of the same way with investing. You can read about all the amazing things management has done and figure out the moat based on your mental models, but if the financials don't back it up, it's meaningless.
If management talks a big game but revenue is decelerating quickly and margins are eroding and guidance is being lowered, you need to know why. Without a deep understanding of the financials, you don't have a foundation to stand on.
13) Then we move onto the balance sheet check-up.
If the company is not yet free cash flow positive, we'll calculate burn rate, see how much debt there is and look at some of the more typical balance sheet calculations. [Feel free to check out our financial analysis course if you would find that helpful].
14) Moving on, we need to know what the industry looks like?
This implies that we've done the work to understand the industry based on our circle of competence. It's important to know the size of the market in case the company has saturated the current customer pool. However, more often than not, if a company is innovating with strong management, market size becomes fluid. For example, on Uber's original pitch deck, they estimate the market at $4 billion.
Source: Original Slide Deck
News flash, Uber is a $55 billion company doing over $12 billion in revenue. That's not to say that happens with every company but it just goes to show that market sizes aren't static.
This also leads into optionality, another undervalued component to look for. Amazon started out in books and now does everything from cloud computing to smart speakers to pill delivery. After all, its logo's arrow is pointing from A to Z.
A clue for this is how the company describes itself.
This is the first line of Amazon's 10-K:
We seek to be Earth’s most customer-centric company.
Notice there's nothing in there about e-commerce. Same idea with Alphabet. Here's its first line:
As our founders Larry and Sergey wrote in the original founders' letter, "Google is not a conventional company. We do not intend to become one."
These companies don't talk about their core product. They talk about what they strive to be. This isn't a mandatory piece of our investing puzzle but it makes us happy when we see it.
BIASES
15) The first question we need to get out of the way is: do I like this just because I have spent a lot of time on it?
I won't spend a lot of time on this one, but we need to break the linear relationship between time-researched and conviction. It's not about the absolute amount of time, it's about the merits of the investment. Sure, you're going to uncover more about a business with more time, but that doesn't necessarily mean it's a better business than a company you just started looking at.
Rather than a 1:1 correlation, we think conviction should be built with a relationship more like this:
16) Am I letting price action color my vision?
In other words, do we like this investment too much just because the stock is down (value) or up (momentum)?
This has probably been my biggest bias over the years; that's why it is called out specifically.
The problem with investing and life I guess is that, in certain situations, the opposite of a mental model can also be true.
For instance, if a stock hasn't moved for a whole year, maybe the market is trying to tell us something? Or maybe, we should ignore the price altogether and focus on the business like good investing boys and girls?
Regardless, it is valuable to stop and think. This checklist item makes sure that happens.
17) Am I di-worsifying?
If you look at a lot of companies, there is a temptation to start falling in love with a lot of them. After all, there are some good businesses out there.
One tactic that is helpful is looking at new businesses with a purpose rather than just looking. When we talked to Bluegrass Capital the second time, that's what he brought up. If we look at competitors of current holdings, we get a better understanding of the space while also learning about a new business.
Thinking about this question forces you to have a benchmark. You must have a favorite stock based on conviction and return profile. This way you can measure new ideas against this one. If the new idea is not as good, simply buy more of your benchmark.
18) Am I seeking to find reasons to like this company rather than just letting the facts speak?
This is one of my favorite questions because it stuns the deadly confirmation bias. We can't become attached to a stock. A stock is merely a vehicle in which we hop into that takes us to our destination (more generosity, financial freedom, kid's college fund, etc.). Picture yourself stranded on a desert road, hitch-hiking, where many cars stop to see if you need a ride. Once you get in a car, you don't have an obligation to stay in, you are free to leave if you so choose.
When there are 4,000+ opportunities out there, we don't need to get attached to a stock. We need to remind ourselves to let the facts speak for themselves.
VALUATION
19. How confident am I in the assumptions to get a 5 year 20% CAGR?
Rather than overcomplicate things, we just make a simple earnings model to see what assumptions are priced into a stock. If we have done all of the work from the previous 18 questions, we probably know the business pretty well.
This, in our view, is more important than the valuation all by itself. We would rather knowingly overpay for a business we knew extremely well than buy a "cheap" business, knowing nothing about it. This stems from our view of risk. We define risk as something that happened which we couldn't account for. If we knew everything (still gotta stay humble, that's why we have position sizing limits) about a business, then we could, theoretically, price in the risk. Without knowing anything, we wouldn't have the conviction to hold on or let go when we most needed to.
ALLOCATION
20. What is my gut-level conviction and the upside potential?
Conviction is a weird thing and though it should change in some circumstances, in others, it shouldn't. We've tried to quantify it as a score before, but it always somehow seems too qualitative, and then, subconsciously, we just end up giving it the score we think it deserves in the first place.
While there is definitely a strong quantitative focus overall, for conviction, we try to synthesize everything we've discussed into a gut-level feel. This is likely an unsatisfying answer, but it allows us to move swiftly if we think something material has changed. This is precisely why we think it is so important to understand the business deeply.
21. Pre-mortem: if this turns out to be a bad investment, what will be the reasons?
This is a great question that forces you to think a little more about the consequences of the business's risks.
Conclusion
If checklists can save lives and millions of healthcare dollars, I'm pretty confident they can help in our investment process. I, along with our members, have definitely benefitted from this practice.
Maybe checklists aren’t that boring after all…
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