Street Capitalist: Event Driven Value Investments

Atul Gawande has a new book called the Checklist Manifesto. Obviously, the book is about checklists and Gawande analyzes their use with in a multidisciplinary manner. He looks at checklists and how they are used by individuals in various occupations where he finds that using them yields successful results. I have not read the book yet, but it looks good and hope to do so soon.

One of my most popular posts dealt with the use of checklists and how they could be adapted for use by value investors. I first wrote about the possible use back in July 2008 after reading Atul Gawande’s article on the same subject with this post. Since then Gawande’s work has made it onto Gurufocus and used by the likes of Mohnish Pabrai:

Gawande tells the story of Mohnish Pabrai, an investment manager in Irvine, California, who may be best known for paying $650,100 along with a friend to eat lunch with the billionaire investor Warren Buffett. Pabrai says many types of investing mistakes — even some made by Buffett — can be avoided by using written checklists.

Lists help Pabrai analyze potential investments more efficiently, Gawande writes. He says Pabrai’s investments more than doubled in a year after he developed checklists to prevent about 70 kinds of errors, such as failing to look for effects tied to boom or bust cycles.

Buffett’s Lunch Date, Surgeons Improve Results With Checklists (Bloomberg)

Checklists have in one way or another been popular among value investors for a long time. Pabrai often cites Charlie Munger’s work in the area and Walter Schloss is said to have used the same kinds of checklist criteria used at the Graham-Newmann partnership when he went off on his own to start his own investment partnership.

To get an idea for how the checklist is applied in disciplines outside of medicine, try looking at these examples from Gawande’s interview with Charlie Rose:

CHARLIE ROSE: You told me that story. Tell me about the B-17 story,
about the checklist.

ATUL GAWANDE: Well, this was part of what I get to think about by being this mixed role. I had a project for the World Health Organization where they asked me to lead a team trying to come up with ways to reduce deaths in surgery.

And what we looked to is we weren’t finding answers in our part of the world, so we looked to the aviation world. And there was a moment where aviation changed. There was a request by the army for a new long-range bomber in 1935, and Boeing came up with a plan to put four engines on the plane.

This was a massive breakthrough. That plane could fly higher, farther, faster. It was clearly the answer for the military. They did a test run, they actually had a flight competition, and the plane crashed, killing the crew onboard.

And the investigation showed nothing wrong mechanically with the plane. The pilot had forgotten to release the elevator controls, and so the plane could climb and climb but couldn’t level out, and so it just lost air and crashed to the ground.

And the reason he forgot was that putting four engines on the plane increased the complexity of how many things he had to remember so much that the army deemed it too much airplane for one man to fly.

What did they do to try to solve that problem? When Boeing built the first production models and the pilot said “I think we can fly this,” they did not make a three-year specialty fellowship in flying the B-17 airplane. They did not throw more and more technology into it.

They just made a checklist. A, before takeoff a few checks on one page, and following those basic checks they were able to fly that plane over almost two million miles without a single mishap and ended up having 13,000 of these planes in World War II. It was the backbone of our air superiority.

And what I realized following that story was that not only in surgery but all across medicine, we’ve hit our B-17 moment. Medicine has become more complex than one person can remember for themselves, too much airplane for one person to fly.

CHARLIE ROSE: Go ahead. So who writes the checklist?

ATUL GAWANDE: So what it almost has to be that the people at the front line write their own checklist.

But what we had to do, we had to learn from Boeing, who has tons of experience on how to do this, how to make a good checklist instead of a bad checklist. Make a way that you are not distracting people, not making it so long that it’s impossible to deal with.

And so they showed us. We ended up following their rules and conducted a two-minute checklist for operating rooms that when we implemented it in eight hospitals, just asking teams to follow this checklist every time, it reduced deaths 46 percent.

CHARLIE ROSE: Forty-six percent?

ATUL GAWANDE: Forty-six percent.

CHARLIE ROSE: Reduced death in the operating room?

ATUL GAWANDE: In 8,000 patients.

I implemented it in my operating room not because I thought we needed it in my hospital. At the Brigham and Women’s hospital we know what we’re doing. I didn’t want to be a hypocrite because I was asking these other hospitals to implement it.

And then, to my surprise, I have not gotten through a week where it has not caught problems that we would have missed.

CHARLIE ROSE: Doesn’t that say something about how many people might have been killed because there was no checklist if these numbers are as astounding as they are? You haven’t gone a week in which you didn’t find you missed something or would have missed something?

ATUL GAWANDE: Not that it would have killed people, but it would have harmed them.

And the striking this is we haven’t taken these lessons elsewhere. I got a note from a patient who — it was just heartrending. He had an merge spleenectomy. And when you lose your spleen, there’s certain vaccines you’re supposed to get. But we forgot to give the vaccines, meaning my profession, we surgeons.

CHARLIE ROSE: He lost his spleen, and if you lose your spleen, you have to have vaccines, and somebody forgot that?

ATUL GAWANDE: Right. And so the result was instead of getting this pneumococcal vaccine he got this infection which you need a spleen to fight off. He ended up losing nearly all of his fingers and toes from a completely preventable problem.

And I’ve seen in my own hospital that we’ve forgotten this kind of a vaccine. We’ve seen these kinds of steps across the board, and we missed them because we think using a checklist is a sign of weakness. Experts don’t need checklists. You become an expert so you don’t have to have a checklist.

But when complexity has exceeded the capability of our brains to handle it, it’s actually more important than technology and more important than any of the things that we fall back on. It’s this very simple, mundane thing.

CHARLIE ROSE: How is it applicable to other areas beyond a surgeon?

ATUL GAWANDE: The fascinating thing to me and the reason — I never imagined I’d write a book about checklists.

CHARLIE ROSE: And look at this little check here.

ATUL GAWANDE: I know.

The profound thing that I found was that as I looked for ideas outside of medicine to apply in medicine, I ran into people in multiple lines of work, whether it’s the skyscraper world or investment world or teaching, who are struggling with the fact that we’ve gone from a world where our main problem was ignorance, we didn’t know what to do, to a world where now we actually have a lot of knowledge, but it’s so voluminous and so complex you can’t keep up with it anymore.

And people are struggling with understanding how do I make sure I do he right thing at the right time the right place. In pockets of areas, people have started applying the checklist, a handful of people in the investment world, a handful of people in restaurants and places like that.

CHARLIE ROSE: A checklist in a restaurant, how would that work?

ATUL GAWANDE: I spent a day in a gourmet kitchen with Jody Adams, a chef in Boston who runs a fabulous restaurant. And I was there because I wanted to see how people really make the art of cooking work when you have to do it for 150 people a night.

And the answer to my surprise was that even for a gourmet chef, you’d think she would carry it in her head. She has a checklist called as recipe that she follows, even the 300th time she’s making a lobster dish, because she says “That’s the moment when I forget to add that crucial spice or ingredient.”

And to make that kitchen run like a symphony with all of its specialists — it’s grill cook, it’s baker, and so on — they have a check in process to make sure that nothing goes in or out, including a little check before the dish goes out the door where the souse chef looks at it before it leaves.

Charlie Rose interviews Atul Gawande (transcript)

You should understand that in each case from the above, the checklist was used to prevent a disastrous outcome. For Boeing a crashed plane, a death in the operating room, or a bad dish produced by Jody Adams’ kitchen. In every case the checklist is strictly adhered to so that mistakes are not made. I think that if you choose to adopt a checklist in your investing process, you need to strictly adhere to it. If not, you will only be giving yourself a false sense of safety.

For an investor, here are some places where I could see checklists work:

1. The net-net hunter: you could easily formulate a list of rules to look for before investing in a net-net. Some of these could be picking a satisfactory discount to net current asset value (current assets – total liabilities), checking inventory levels and what that inventory actually consists of, the burn rate of cash, management’s view on capital allocation, including PP&E that can be easily liquidated, and any other long term assets that would be attractive to buyers.

2. The bank investor: before looking at a bank you really need to give them a quick look over quantitatively. Most of the mistakes I see by people investing in banks is that they fall in love with the story and qualitative factors without rigorously analyzing the bank on the quantitative side. I like to see banks that are well-capitalized, have loan portfolios that are light in commercial real estate, feature diverse income streams, appear to be working through their credit problems, and are putting the excess capital to work by either pursuing buybacks or dividends.

3. The Memento Mori list: when Roman commanders returned from battle, they often had slaves whispering “memento mori” into their ears or, “you are only mortal.” You end up picking up a lot of knowledge about companies, industries, and accounting details over the course of your investing career, particularly by learning from your failures. I saw during the crisis that many engineering contracting firms appeared to be trading at close to the value of their cash. But what happened was as the crisis intensified, contracts were canceled and the cash that was recorded from those contracts vanished from the balance sheet. That would be something to look out for when analyzing similar companies, some investors like Joel Greenblatt actually advocate discounting cash up front. Another lesson that is applicable today is the fact that banks are capable of writing down the value of assets. A lot of investors thought they were getting Bank XYZ at 1/2 book value during the crisis, when in the next quarter book value would drop in response to asset write downs. You could add more to this list, given areas where you failed.

Most investment failures stem from A. buying a business above its intrinsic value, B. misjudging the company’s management, or C. investing in a business where the long term economics were worse than expected. Those are what you would want to be making a checklist to protect against. These are just some checklists that I have thought about, but if you have your own, feel free to use the comments section and share.