This is a continuation from our previous post (Alpha Theory Best Practices (Part Four))
Best Practice #5: THE CHECKLIST MANIFESTO
“When we look closely, we recognize the same balls being dropped over and over, even by those of great ability and determination. We know the patterns. We see the costs. It’s time to try something else. Try a checklist.” Atul Gawande, Author of “The Checklist Manifesto”
In the book “The Checklist Manifesto”, Atul Gawande attempts to show how the use of a checklist can provide structure in complex systems (building a skyscraper) and how it can prevent the mundane mistake from becoming catastrophic (not administering an antibiotic at the proper time before surgery). The companies you invest in are complex systems that are too broad and dynamic to juggle in one’s brain. They are also subject to overlooked mundane mistakes causing major problems.
For example, think of spending a day researching a company only to find out it isn’t liquid enough to put on a real position. Checklist are boring. Checklist are tedious. But checklist keep skyscrapers from falling down, patients dying from infection, and may prevent you from spending too much Mental Capital on a short idea that has 30% short interest and a 20% cost to borrow.
Many of the best managers I’ve worked with have an “idea template” or “research note” that provides a framework for every investment. Of course, investments come in all different shapes and sizes and don’t fit into neat little frameworks, but there are some basic facts that should be answered before an investment is made that can be easily overlooked if not asked for specifically. Reliance on the analyst or PM to remember to ask ALL the right questions is a waste of their mental resources. Build a checklist and you’ll make sure the basics are covered.
I would imagine you could think of 25 facts you want to know about every stock you invest in, like:
- 1. PE and EBITDA mutiple
- 2. Industry PE and EBITDA multiple
- 3. 10 Year Average/High/Low PE and EBITDA multiple
- 4. Short Interest
- 5. Cost to Borrow
- 6. Insider Holdings
- 7. Debt (Maturities and Covenants)
- 8. Leverage metrics
- 9. Liquidity
- 10. Correlation with the existing portfolio (Marginal Contribution to Risk)
- 11. Accounting Ratios
This list is certainly not exhaustive and some may be irrelevant for you, but you get the point. Creating a list of the things that you believe are hallmarks of good investments or are warning signs will help keep simple things from slipping through the cracks. Let the list be dynamic. Cull those things that are not impactful and predictive and add those that you learn to be. If the checklist does nothing more than prevent you from spending too much time researching an investment that doesn’t pass basic hurdles, then it has provided tremendous value. Take the time to read “The Checklist Manifesto” and judge for yourself if your process could benefit from a Checklist.