Street Capitalist: Event Driven Value Investments

My friend Miguel Barbosa has an excellent interview with James Montier (of GMO and author of: Value Investing: Tools and Techniques for Intelligent Investment). I thought I would give you a couple of excerpts, I believe the whole interview is worth reading and suggest you do so. Miguel tells me that he should have his second part up soon.

A few days ago, when discussing value investing, a friend asked me why value investing does not stop working. Value investing thrives because of certain inefficiencies in the market and it has been written about for more than 70 years now. So why doesn’t the market catch on? Montier provides us with an answer:

Miguel: Tell us about the price = quality heuristic? Why do investors overpay for beauty and underpay for toads…after all they are one step away from becoming princes are they not? This heuristic complements the Anginer et all study where ugly defendants are more likely to be found guilty and receive longer sentences than attractive defendants.

James Montier: We humans have a bizarre bias against a bargain. For instance, my friend Dan Ariely has done some great experiments in this field showing some pretty odd findings. Imagine you taste two glasses of wine one you are told comes from a $10 bottle, the other comes from a $90 bottle. You will almost certainly say that the $90 wine tastes much better. The only snag is that the two wines are exactly the same. So never come to dinner at my house, because I’ll give $10 wine, and tell you it costs $90!

The same thing happens with pain killers. It is why branded pain killers exist alongside generic equivalents. They both have exactly the same active ingredient, but people report the branded version works better.

I suspect that something similar happens with stocks. Stocks are the one thing we don’t like to see on sale. So a ‘cheap’ stock must have something wrong with it, and an ‘expensive’ stock must be a sign of quality – at least that’s the way we tend to view things.

The Anginer et al study shows some similar findings in the legal context. Ugly defendants get far worse sentences, than attractive defendants. We have a hard time believing that attractive people could have been bad – a kind of halo effect, if you will.

If you haven’t already, I really suggest you read Dan Ariely’s book Predictably Irrational, it is one of my favorites. Montier gets at why I think markets wont figure out value investing — the participants are too irrational. Usually, what you will see are investors who claim to practice value investing, only to abandon it when things get tough. It is a style of investing that requires levelheadedness, courage, and patience, which many investors lack.

One of the topics Montier touches on is short selling, which I thought was pretty interesting. Most value investors don’t short, so it is always nice to take a look at the ones who do:

Miguel: Tell us about the folly of using price to sales as a proxy for value.

James Montier: Price to sales is fine if you are looking for short candidates, but as a long side value criteria it makes no sense to be at all. After all as long as you promise to value me on price to sales, I’ll set up a business selling $20 bills for $19…I’ll never make a profit, but if you are looking at price to sales you won’t care.

Price to sales is typical of the drift up the income statement when the bottom line gets too demanding. If your PE starts to look expensive, get everyone to look at a less demanding metric, enter stage left price to sales. If that starts to look tough, abandon the income statement and look at the value based on eyeballs and clicks!

Miguel: What I enjoy about your writing is that you aren’t afraid to talk about “controversial topics” – yes I’m talking about your work on short selling. Can you quickly tell us what you have learned about short sellers (their characteristics, screens, etc).

James Montier: Short sellers are everyone’s favorite scapegoats. They make money when things go ‘wrong’. Of course, what the authorities forget is that simply because a short seller sells a stock, doesn’t mean it goes down – if only it were that easy we’d all be short sellers. As David Einhorn observed, I’m not critical because I’m short, I’m short because I‘m critical.

In my experience, short sellers are amongst the most fundamental investors you’ll come across. They understand the ins and outs of a business better than just about everyone else. They are highly skilled at figuring out poor economics when they see if. They act as acting police, helping to uncover fraud – something that the regulators used to do (a very long time ago).

My own work on short selling has focused on a number of areas. In general, shorts tend to come into a couple of categories: bad businesses (i.e. poor economics), bad accounting (obvious), bad management (the guys at the top haven’t got a clue). In addition I often look for several traits, such as expensive, unrealistic growth expectations, too much debt, and poor capital discipline (i.e. needless and tangential M&A).

I also created a measure called the C-score (C is for cheating or cooking the books). It aims to look for the quantitative red flags which often accompany bad accounting.

Excerpt: Details of the C score Page 263 of Value Investing Tools & Techniques for Intelligent Investment

1. A growing difference between net income and cash flow from operations.
2. Day sales outstanding is increasing.
3. Growing days sales of inventory
4. Increasing other current assets to revenues.
5. Declines in depreciation relative to gross property plant and equipment.
6. High total asset growth.

Miguel Barbosa interviews James Montier (Simoleon Sense)

Those are just two questions that Montier answered. There are many more over at Simoleon Sense and I highly recommend the interview.

Meridee A. Moore runs Watershed Asset Management, a $2B hedge fund in San Francisco. She gave the NYTimes an interview on management, and I thought the following test she gives analysts is pretty interesting:

Q. What are some other screens?

A. We give people a two-hour test. We try to simulate a real office experience by giving them an investment idea and the raw material, the annual report, some documents, and then we tell them where the securities prices are. We say: “Here’s a calculator, a pencil and a sandwich. We’ll be back in two hours.” If an analyst comes in there and just attacks the project with relish, that’s a good sign.

Q. Is this one of those impossible tests, where you’re asking them to do seven hours of work in two hours?

A. Yes. But you’d be amazed at how well people do. After two hours, two of us go in and just let the person talk about what he’s done. The nice thing about my being trained as a lawyer, and never going to business school, is that I’m able to ask the basic, financially naïve questions, like: “What does the company do? How do they make money? Who are their customers? What do they make? How do they produce it?” That throws some people off.

Q. Really?

A. Often, analysts go right to the financials and forget to think about the company’s business model. If the person avoids answering the basic questions and instead changes the subject to talk about the work they did, that tells me the person is a bit rigid. Instead of trying to respond to what’s being asked, they’re trying to get an A on the test.

Also, if they’re a little too worried about pleasing me, that’s not good, either, because it’s not a please-the-boss competition. The point of the exercise is to make sure that we’ve thought about the issues critically, so we are in a position to make a good investment decision.

The other quality we look for is whether the person can distill a lot of very complicated information down to its essence. Can you figure out the three or four issues that are most important for understanding this investment? Or do you get distracted by aspects of the company that really have nothing to do with making an investment or determining value?

An Office? She’ll Pass on That (NY Times)

This is kind of funny for me. It sounds stupid, but when I decide to look at a company, my first task is to scribble “How they make money: …” and use that to shape the rest of my analysis. I’ve found I often make mistakes when I try to tackle things from a purely financial perspective and it helps to take a step back and look at how to business works and then see how that translates into its financials.

Hunt Alcott, a behavioral economist with MIT, talks about improving consumer decision making when it comes to making better choices regarding energy usage. I thought it was pretty interesting that he cites Robert Cialdini’s work in psychology. As you know, Cialdini’s book Influence: The Psychology of Persuasion is one of Charlie Munger’s favorites:

Q. To what extent will consumers make different choices if they simply have the facts about energy explained to them in a clear manner?

A. The effect of clearer information is an empirical question that often has surprising answers. One example of this is from OPOWER, a company that our research group interacts with a lot. OPOWER sends home energy use reports to households that compare those households to their neighbors and give energy conservation tips. The information in these reports is very similar to what’s already on a utility bill: How much did you spend this month, how much did you spend this year, here’s where you can get compact fluorescent lightbulbs. But something about the way they’re presenting it — presumably the way they use comparisons to neighbors — seems to be very powerful. I’m not sure it would have been obvious to any of us 10 years ago or three years ago that this program would have large effects in the real world.

There was an academic study by psychologist Bob Cialdini and co-authors that helped provide the proof-of-concept for the OPOWER program. In this study, the researchers left door-hangers at a group of households in California. Some of the door-hangers said, “Save money by saving energy,” some of them said, “Save the environment,” and some said, “Here’s how much your neighbors are using.” And the ones that said, “Here’s how much your neighbors are using” had a much stronger impact on energy consumption. In the last couple of years that study in particular has had a lot of influence.

Q. Okay, so why is it that referring to neighbors is effective?

A. Psychologists have been great at documenting that if you tell people what the social norm is, people will converge to the social norm. In my mind there are two leading economic hypotheses for why this works in energy consumption. One is called “conditional cooperation.” People may be altruistic, and they view conserving energy as contributing to the public good of reducing climate change. People are typically more willing to contribute to a public good if they are informed that other people are contributing more than they are.

The other explanation is just social inference. It could be that I couldn’t care less about the environment, but I do want to save money. And if you tell me that I’m using twice as much energy as my neighbor, that lets me know that maybe I’ve been leaving a window open or that my furnace is inefficient. So that’s purely a self-interested, informational story. Testing between these two explanations is one of the research questions we’re interested in.

3 Questions: Hunt Alcott on behavioral economics and the energy crisis (MIT)

This is a real gem:

But I was mistaken. There was never a prize in the lot. I could read of railway accidents every day — the newspaper atmosphere was foggy with them; but somehow they never came my way. I found I had spent a good deal of money in the accident business, and had nothing to show for it. My suspicions were aroused, and I began to hunt around for somebody that had won in this lottery. I found plenty of people who had invested, but not an individual that had ever had an accident or made a cent. I stopped buying accident tickets and went to ciphering. The result was astounding. ‘THE PERIL LAY NOT IN TRAVELLING, BUT IN STAYING AT HOME .

I hunted up statistics, and was amazed to find that after all the glaring newspaper headings concerning railroad disasters, less than three hundred people had really lost their lives by those disasters in the preceding twelve months. The Erie road was set down as the most murderous in the list. It had killed forty-six — or twenty-six, I do not exactly remember which, but I know the number was double that of any other road. But the fact straightway suggested itself that the Erie was an immensely long road, and did more business than any other line in the country; so the double number of killed ceased to be matter for surprise.

By further figuring, it appeared that between New York and Rochester the Erie ran eight passenger trains each way every day — sixteen altogether; and carried a daily average of 6,000 persons. That is about a million in six months — the population of New York city. Well, the Erie kills from thirteen to twenty-three persons out of its million in six months; and in the same time 13,000 of New York’s million die in their beds! My flesh crept, my hair stood on end. “This is appalling!” I said. “The danger isn’t in travelling by rail, but in trusting to those deadly beds. I will never sleep in a bed again.”

(Mark Twain Quotes)

Most people fixate on interesting accidents over frequent accidents. This often causes sensationalist reporting and people start to fear a shark attack over crashing into a deer, even though the latter is 300 times more likely to occur.

For investors there are some take aways too. If you talk to an ordinary person about what they are interested in investing in, you are likely to be disappointed. Most would rather have the thrill and excitement in investing in what everyone thinks will be the next big thing. But if you look at the evidence from the past, these investments are usually almost always failures. The powers of creative destruction almost always ensure that new industries are rife with failures as businessmen gradually figure out the right economics. Instead, You are much better off looking at industries that have withstood the test of time and are trading at undervalued levels.

(Flickr: Mikey G Ottawa)

Drake Bennett at the Boston Globe has an interesting article on cognitive fluency. Basically, he cites research that says the more simple or familiar something is, the more persuasive it becomes:

One of the hottest topics in psychology today is something called “cognitive fluency.” Cognitive fluency is simply a measure of how easy it is to think about something, and it turns out that people prefer things that are easy to think about to those that are hard. On the face of it, it’s a rather intuitive idea. But psychologists are only beginning to uncover the surprising extent to which fluency guides our thinking, and in situations where we have no idea it is at work.

Psychologists have determined, for example, that shares in companies with easy-to-pronounce names do indeed significantly outperform those with hard-to-pronounce names. Other studies have shown that when presenting people with a factual statement, manipulations that make the statement easier to mentally process – even totally nonsubstantive changes like writing it in a cleaner font or making it rhyme or simply repeating it – can alter people’s judgment of the truth of the statement, along with their evaluation of the intelligence of the statement’s author and their confidence in their own judgments and abilities. Similar manipulations can get subjects to be more forgiving, more adventurous, and more open about their personal shortcomings.

Because it shapes our thinking in so many ways, fluency is implicated in decisions about everything from the products we buy to the people we find attractive to the candidates we vote for – in short, in any situation where we weigh information. It’s a key part of the puzzle of how feelings like attraction and belief and suspicion work, and what researchers are learning about fluency has ramifications for anyone interested in eliciting those emotions.

“Every purchase you make, every interaction you have, every judgment you make can be put along a continuum from fluent to disfluent,” says Adam Alter, a psychologist at the New York University Stern School who co-wrote the paper on fluency and stock prices. “If you can understand how fluency influences judgment, you can understand many, many, many different kinds of judgments better than we do at the moment.”

Easy = True (Boston.com)

I can definitely see the use of rhymes and folksy/familiar manners of speaking increase the persuasiveness of your writing. If someone is writing in a very complicated manner, filled with jargon, the reader should be more focused and scrutinizing than if they were presented with a simple letter between friends. Note how Warren Buffett speaks in his letters.

For investors, understanding cognitive fluency could be helpful. I don’t know if I buy the companies with easy to pronounce names argument, but I do believe strong brands are helpful. Companies that are able to evoke familiar images and feelings may have a strong affect on consumers. This could be similar to Warren Buffett’s ideas about how See’s Candies manages to do so well on Valentine’s Day sales.

Read the full article for more details.

This week’s New Yorker has a great article (New Yorker digital subscribers click here) by Malcolm Gladwell on entrepreneurship. Gladwell finds that entrepreneurs are actually not the high octane risk-takers that they are made out to be. Instead, successful entrepreneurs are highly rational actors, akin to predators who follow systemized patterns and go after safe prey. The article prominently features John Paulson’s CDS trade but also refers to a number of other fascinated entrepreneurs like Sam Walton and Ted Turner. While the article wont be available online for a while, I thought I’d quote some excerpts that I feel are worthy of discussion.

At 24 years old, Ted Turner became the CEO of his family’s outdoor advertising business after his father committed suicide. The business was actually quite good and threw off a lot of cash while requiring little by way of capital expenditures.

Turner sought to expand his empire and went after WJRJ, a UHF TV station that was down on its luck:

It was housed in a run-down cinderblock building near a funeral home, leading to the joke that it was at death’s door. The equipment was falling apart. The staff was incompetent. It had no decent programming to speak of, and it was losing more than half a million dollars a year. Turner’s lawyer, Tench Coxe, and his accountant, Irwin Mazo, were firmly opposed to the idea… The purchase price of WJRJ was 2.5 million. Similar properties in that era went for many times that, and Turner paid with a stock swap engineered in such a way that he didn’t have to put a penny down.

Most successful dealmakers that have built real empires all have the ability to find deals with great tax treatments. The Pritzkers of Chicago, John Malone of Liberty Media, and Sam Zell have all sought out these types of deals. Turner also recognized these benefits:

WJRJ’s losses could be used to offset the taxes on the profits of Turner’s billboard business. The television station, furthermore, fit very nicely into his existing business. Turner was very experienced at ad-selling. WJRJ may have been a virtual unknown in the Atlanta market, but Turner had billboards all over the city that were blank about fifteen per cent of the time. He could advertise his new station for free.

Most of these entrepreneurs use these deals to pick up NOLs at low prices which drastically reduce the taxes paid by the businesses they run. These boost profitability and gives them an advantage over competitors. Gladwell also seeks out academic research on entrepreneurship, in order to find patterns that are displayed my large groups of successful businessmen.

First, he cites the work of Michel Villette and Catherine Vuillermot (From Predators to Icons). One of the things that Villette and Vuillermot find is that most successful entrepreneurs are not one-hit wonders. Instead, they find some kind of inefficiency in the business landscape and actively exploit it:

There is almost always, they conclude, a moment of great capital accumulation — a particular transaction that catapults him into prominence. The entrepreneur has access to that deal by virtue of occupying a “structural hole,” a niche that gives him a unique perspective on a particular market.

Villette and Vuillermot go on, “The businessman looks for partners to a transaction who do not have the same definition as he of the value of the goods exchanged, that is, who undervalue what they buy from him in comparison to his own evaluation.” He moves decisively. He repeats the good deal over and over again, until the opportunity closes, and — most crucially — his focus throughout that sequence is on hedging his bets and minimizing his chances of failure. The truly successful businessman, is anything but a risk-taker. He is a predator, and predators seek to incur the least risk possible while hunting.

If you take a moment to think about businessmen and investors who have had extraordinary success, they all seem to exhibit this trait. Most great businesses occupy a space in their industry where they are protected by the wide moat of their competitive advantages. Usually, it is a result of growing and growing until you almost monopolize your sector.

John D. Rockefeller saw an inefficiency in the oil refinery market and quickly moved. He realized that by securing rates with the railroad companies, he could at least gain a cost advantage over competitors. He also realized the economies of scale that could be had by acquiring competitors. At the time, running an oil refinery was a terrible business, many became bankrupt. But Rockfeller was able to build Standard Oil with acquisition after acquisition and emerge with a monopoly.

Sam Walton saw that rural communities were not being served by large discount retailers such as Kmart. He didn’t just open one Walmart, he opened many, using airplane flyovers to find untapped markets that would also connect advantageously with Walmart’s supply-chain system. Walmart grew so large that competitors from urban areas were unable to penetrate his geographic foothold. Walmart was then able to enter urban markets with ease and topple competitors to become America’s most successful retailer.

Ray Kroc saw a market for America’s first nationwide fast-food chain as he sold milkshake machines around the country. What he found were great hamburger restaurants run by people with no entrepreneurial drive behind them to actually franchise them. After encountering McDonald’s in 1954, Ray Kroc sealed a deal to become the company’s sole franchisee and grew the hamburger chain outside of Arizona and California. Today, McDonald’s is the world’s biggest hamburger chain.

While Gladwell refers to John Paulson as an investor who has exhibited these traits recently, Sardar Biglari may be a better example. Biglari started his hedge fund using money from a tech company that he started and sold while in college. He then went on to one by one, target fast-food companies that had high concentrations of company-owned restaurants on their balance sheets. Many of these chains were quite old so it was likely that the real estate, recorded at a cost on the balance sheet, was dramatically undervalued relative to their current market values. All together, Biglari targeted five restaurant chains: Western Sizzlin, Friendly’s, Applebee’s, the Steak ‘N Shake Company, and Jack in the Box. Biglari was able to get on the boards and take control of both Western Sizzlin and Steak ‘N Shake, eventually merging the two. Applebee’s and Friendly’s were both bought out by other companies. Biglari’s least successful attempt was with Jack in the Box, but since he only agreed to exchange shares of Western Sizzlin for Jack in the Box, the cost was virtually nothing.

The other thing Gladwell finds is that most entrepreneurs are able to find inventive ways of financing their business ventures:

Giovanni Agnelli, the founder of Fiat, financed his young company with the money of investors — who were “subsequently excluded from the company by a maneuver by Agnelli,” the authors point out. Bernard Arnault took over the Bousac group at a personal cost of forty million francs, which was a “fraction of the immediate resale value of the assets.” The French industrialist Vincent Bollore “took charge of the failing family company for almost nothing with other people’s money.” George Estman, the founder of Kodak, shifted the financial risk of his new enterprise to his family and to his wealthy friend Henry Strong.

For the entrepreneur, cheap and secure financing can drastically improve the chances of an enterprise’s survival. By investing little of his own money, the entrepreneur can amplify returns on his own invested capital while keeping dry powder in reserve for new opportunities. Most successful real estate developers exhibit the same trait as do private equity firms, little equity is actually invested in the properties acquired in favor of debt. This often leaves the newly privatized properties in danger of default in the case of a sudden economic downturn, while keeping the fortunes of the owners largely in tact.

Gladwell emphasizes the fact that Ted Turner was also averse to using cash in his acquisitions. He explains by using Turner’s purchase of the Atlanta Braves as a case:

The team was losing a million dollars a year, and the owners wanted ten million dollars to sell…

He talked the Braves into taking a million down, and then the rest over eight or so years. Second, he didn’t end up paying the million down. Somewhat mysteriously, Turner reports that he found a million dollars on the team’s books — money the previous owners somehow didn’t realize they had… He now owed nine million dollars. But Turner had already been paying the Braves six hundred thousand dollars a year for the rights to broadcast sixty of the team’s games. What the deal consisted of, then, was his paying an additional six hundred thousand dollars or so a year, for eight years: in return, he would get the rights to all a hundred and sixty-two of the team’s games, plus the team himself…

Turner is a cold-blooded bargainer who could find a million dollars in someone’s back pocket that the person didn’t know he had.

Many successful businessmen and investors seek out hidden assets when doing acquisitions. Often, the value of assets are sometimes obscured by accounting or the market climate. One of Warren Buffett’s most famous investments was in the Sanborn Map company. In 1961 the stock made up 35% of his partnership’s assets and gave him a spot on the company’s board. Astonishingly, while Sanborn sold for $45 per share on the market, the company had an investment portfolio of more than $65 per share. At the time, a buyer of Sanborn stock received an undervalued investment portfolio and a map business thrown in for free.

Using research from economist Scott Shane, Gladwell delves into the notion that the entrepreneur is a risk taker and gives reasons for why entrepreneurs fail:

…many entrepreneurs take plenty of risks — but those are generally the failed entrepreneurs, not the success stories. The failures violate all kinds of established principles of new-business formation. New-business success is clearly correlated with the size of initial capitalization. But failed entrepreneurs tend to be wildly undercapitalized. The data show that organizing as a corporation is best. But failed entrepreneurs tend to organize as sole proprietorships. Writing a business plan is a must; failed entrepreneurs rarely take that step. Taking over an existing business is always the best bet; failed entrepreneurs prefer to start from scratch. Ninety per cent of the fastest-growing companies in the country sell to other businesses; failed entrepreneurs try selling to consumers, and, rather than serving customers that other businesses have missed, they chase the same people as their competitors do. The list goes on: they undermine marketing; they don’t understand the importance of financial controls; they try to compete on price. Shane concedes that some of these risks are unavoidable: would-be entrepreneurs take them because they have no choice. But a good many of these risks reflect a lack of preparation or foresight.

Some of the reasons for failure may seem counterintuitive to a person who is seeking to start their own business. Many may balk at the prospect of taking over an existing business, but if it is a forced sale due to owner’s health or a decision to retire, a budding entrepreneur may have the opportunity to acquire a good business at a low price. This kind of thinking requires the entrepreneur to employ the kind of rational judgment that is totally counter to the cowboy image the media perpetuates.

Another of these traits is not caring what other people think. Gladwell notes that many successful entrepreneurs are willing to risk their personal reputation for their business. He contrasts the behavior of banking CEOs who kept piling up bad investments because they feared standing out from the crowd with Sam Walton’s decision to seek financing from his in-laws a second time after failing at his first venture:

Villette and Vuillermot point out that the predator is often quite happy to put his reputation on the line in pursuit of the sure thing…

If an awkward family reunion was the price Walton had to pay for a guaranteed line of credit, then so be it. He went out of his way to take a personal risk in order to avoid a professional risk. Reputation, after all, is a commodity that trades in the marketplace at a significant and often excessive premium. The predator shorts the dancers, and goes long on the wallflowers.

If there is one thing that is really representative of the entrepreneurial stereotype, it is the unflinching persistence that seems to be exhibited by all the examples used in the article. Gladwell ends with a story about the lengths Turner went to, to take back his family’s outdoor advertising business:

He hired away the General Outdoor leasing department. He began “jumping” the company’s leases– that is, persuading the people who owned the real estate on which the General Outdoor billboards sat to cancel the leases and sign up with Turner Advertising. Then he flew to Palm Springs and strong-armed Naegele into giving back the business…

Naegele, by the way, asked for two hundred thousand dollars, which Turner didn’t have. But Turner realized that for some o ne in Naegele’s tax bracket a flat payment like that made no sense. He countered with two hundred thousand dollars in Turner’s Advertising stock…

“I had kept the company out of Naegele’s hands and it didn’t cost me a single dollar of cash.” Of course it didn’t. He’s a predator. Why on earth would he take a risk like that?

Here, Turner really serves as an example for all entrepreneurs. His father had sold General Outdoor and committed suicide shortly afterwards. Such an event must have been emotionally jarring for someone like Turner, but he managed not to be constrained by grief and moved into action. All of his decisions, from poaching personnel to exploiting his adversary’s tax status exemplified the kind of clear-sightedness that is necessary for long-term entrepreneurial success. For the entrepreneur and investor, being able to keep calm emotionally is an absolute need when faced with the daily competitive pressures and changing landscape of the market.

The entire article is worth the read, I would suggest seeking out a copy from your news stand or purchasing a digital subscription, these excerpts are just a small part of it. This is especially true if you are interested in John Paulson. Gladwell dedicates a large part of the article to discussing how and why Paulson managed to earn billions of dollars by purchasing credit default swaps.

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.

(from one of my favorite films: Searching for Bobby Fischer)

In 2009, Charlie Munger recommended Malcolm Gladwell’s book Outliers which studiers outliers throughout history and discipline to find commonalities. One of the ideas professed by Gladwell is a 10,000 hour rule, where if you want to master something you must practice it for at least 10,000 hours. Gladwell uses the Beatles as evidence of this rule, pointing out that their time in Germany was spent constantly performing live which helped them gain the mastery needed to become great musicians when playing concerts and on TV.

The folks over at Study Hacks find that in chess, to become a grandmaster, you do not just need to spend 10,000 hours practicing chess. You must also spend those hours doing the right kind of work or deliberate practice.

1. It’s designed to improve performance. “The essence of deliberate practice is continually stretching an individual just beyond his or her current abilities. That may sound obvious, but most of us don’t do it in the activities we think of as practice.”

2. It’s repeated a lot. “High repetition is the most important difference between deliberate practice of a task and performing the task for real, when it counts.”

3. Feedback on results is continuously available. “You may think that your rehearsal of a job interview was flawless, but your opinion isn’t what counts.”

4. It’s highly demanding mentally. “Deliberate practice is above all an effort of focus and concentration. That is what makes it ‘deliberate,’ as distinct from the mindless playing of scales or hitting of tennis balls that most people engage in.”

5. It’s hard. “Doing things we know how to do well is enjoyable, and that’s exactly the opposite of what deliberate practice demands.”

6. It requires (good) goals. “The best performers set goals that are not about the outcome but rather about the process of reaching the outcome.”

If you’re in a field that has clear rules and objective measures of success — like playing chess, golf, or the violin — you can’t escape thousands of hours of DP if you want to be a star. But what if you’re in a field without these clear structures, such as knowledge work, writing, or growing a student club?

…It seems, then, that if you integrate any amount of DP into your regular schedule, you’ll be able to punch through the acceptable-level plateau holding back your peers. And breaking through this plateau is exactly what is required to train an ability that’s both rare and valuable (which, as I’ve argued, is the key to building a remarkable life).

This motivates a crucial question: What does DP look like for fields that don’t have a tradition of performance-optimization, such as knowledge work, freelance writing, entrepreneurship, or, of course, college?

The Grandmaster in the Corner Office: What the Study of Chess Experts Teaches Us about Building a Remarkable Life (Study Hacks)

For any investor seeking to become better, deliberate practice is essential. The key is figuring out what deliberate practice should consist of in investing. Most of us read newspapers and blogs daily. This helps keep up to date with what is going on in the world. But is that enough? I am not too sure.

I think that taking a more active approach with news reading would be helpful. Recently, the Wall Street Journal ran an article about how David Tepper bought Bank of America stock at its low. A good exercise would be to actually sit around and try to reverse engineer that investment. Eddie Lampert has said that in college he reverse engineered many of Warren Buffett’s investment. This kind of activity would not only increase your understanding of investing but also build a model for you to look at if you ever find a similar investment.

Other investors strive to read one 10K a day. This can help build your circle of competence, but I believe it has some shortcomings. A more targeted approach with 10Ks will be more beneficial than simply jumping from reading about Exxon to reading about Bank of America. You should define goals where you are mastering knowledge of a specific industry or area of the market.

Maybe you want to learn the billboard/outdoor advertising business. Instead of looking at just Lamar Advertising (NASDAQ:LAMR) you would look at Clear Channel Outdoors (NYSE:CCO) as well. If you want to master restaurants, you would maybe start at a fast food company like McDonalds (NYSE:MCD) which is the best in its class. Then seek out Chipotle (reputed to have the best economics in the fast food business) and branch out so that you build familiarity with the industry which will help you evaluate lesser known companies like Steak N Shake (NYSE:SNS).

Feel free to use the comments or e-mail me with suggestions for implementing deliberate practice in investing.