The Safal Niveshak Mastermind ‘Module 6 | Lesson 43 uo The Safal Niveshak Mastermind Power of Investment Checklists Module 6 | Lesson 43 Imagine going to a doctor with a stomach pain after you have been operated upon. The doctor asks you to get an x-ray done. The x-ray report shows a piece of sponge in your tummy. ras Frightening, isn’t it? This could be life threatening. As per a study done by the World Health —_ Organisation, such medical mistakes result in around 7 million people getting disabled every year. One reason this number is not higher is that doctors use what is known as a ‘checklist’ before and after every operation. Medical treatments have become so complex that it is difficult for doctors to keep personal check on each and every procedure. Mistakes still occur. But then the number of such mistakes is greatly reduced due to the use of such checklists. So, checklists save lives. The US Air Force introduced the concept of checklists decades ago. These have enabled pilots to fly aircrafts at mind-boggling sophistication. Innovative checklists are now used in hospitals around the world. These help doctors and nurses respond to everything from common cold to epidemics. Even in the complex world of medical surgery, a simple 90-second checklist has cut the rate of fatalities by more than a third. ‘A fair amount of research has been done in the past that suggest the immense value of checklists. Checklists are valuable as these help short circuit the human brain in a way that it wants to work against us. We generally are overconfident of our capabilities. A checklist can remind us that we are not infallible, that we do make mistakes, and not to be too sure about our decisions. Investing in stocks is not as complex as doing a medical surgery or flying an airplane. But checklists play a very important role when it comes to investing in stock markets. www.safalniveshal.com Page 10f 8The Safal Niveshak Mastermind ‘Module 6 | Lesson 43 How We Invest Too often, most of investors buy stocks by relying on recommendations from other investors, or on hunches, or because of isolated facts we've heard or read about a business. When you make your purchase decisions on these factors and do not take the time to thoroughly understand the businesses you are buying, you're more prone to make investment mistakes. Your decision-making then becomes dangerous because you don’t really know enough, and you're relying on other people and the information (or misinformation) they provide about a particular stock. Instead, your investment purchases should be based on understanding the value of a business through in-depth research. If you truly understand the value of a business, then you will be in @ position to recognize investment opportunities and can more easily make buy or séll decisions. Many professional investors believe that in-depth research is/a waste of time. To them, great investment decisions boil down to a few simple-factors, such as an extremely low stock price. I used to subscribe to this theory myself, but over time, I discovered I was wrong. As I came to appreciate that the value of a business catinot be condensed into a few simple factors, I searched for books that would teach me how to value a business and invest intelligently in stocks. I was looking for a\practical book instead of one that focused on broad concepts. In spite of the fact that there are hundreds of books written on the subject of investing, I honestly couldn't find one that truly helped me. My instinct after failing to find a good investing framework was to over-research potential investments. I often ended up reading everything I could get my hands on about a potential investment. As a result, I subjected myself to information overload and was unable to recognize good information. Lalso kept repeating investmentymistakes, such as paying too much for a business or partnering with the wrong management team. So I set out to establish’ a systematic process to force me to think through my investment ideas more/earefully and help me avoid repeating the same investment mistakes. Over the past few years, I began to use checklists of questions I needed to answer to make:informed investment decisions — questions that would guide me in learning about, say, a business’s competitive position and management strength. ‘As I used the,checklists, I discovered that if I could answer the majority of the questions on the checklist, I could more easily value the business by minimizing the number of assumptions I was making about a business's future prospects. If I was unable to,aMswer a question on the checklist (such as “are its managers honest?”), then’ Dould identify the potential risks I was taking in an investment and the areas that Ineeded to spend more time researching. www.safalniveshal.com Page 2 of 8The Safal Niveshak Mastermind ‘Module 6 | Lesson 43 The Investing Checklist 1. A Business You Understand ovaerr Do I understand this industry? Is it industry within my circle of competence? Do I understand this business? How does the business make money? How has the business evolved over time? Does the industry have a high degree of change and obsolescence? II. Good Long-Term Economics PI OTS Can the market for the company grow at above 10%+ per arfum im volumes over the next 10 years? Can the company grow its sales and profits at 15%+ and maintain ROE in excess of 20% for next 10 years? Does the business have a sustainable competitive advantage and what is its source? Does the business have high/low entry/exit barriers? Does the business possess the ability to raise prices without losing customers? What is the competitive landscape, and how intense is the competition? Does the business enjoy power against its suppliers? Has the recent good performance largely been due to a cyclical upturn in the industry or is it sustainable? III. Good Financial Strength L Has the company been growing its sales and profits consistently over the past 8-10 years? (Note — A new, small company can be growing very fast over the past 3-5 years, but may not be able to’sustain that growth) Has the company earned more than 15% ROE (consistently) over the past 8-10 years, and what has been‘the driver of the same (Du Pont analysis would tell you this) Does the company have 5.0.7 times debt/equity (Unless it is a bank / finance institution)? Does the company have & large FCCB borrowing (foreign currency convertible bonds)? Does the industry have high capital intensity (Sales / FA+NWC < 1.5)? Does the company earn rising and positive FCF? If not, does it have the potential to do so in the future? IV. Able & Trustworthy Management Does the management have integrity ~ any anti-shareholder resolutions in the past? Does the management discuss both negative and positives of the company performance candidly? Has the management invested incremental cash at 15%+ ROE levels? Is the management hoarding cash without raising dividend or reinvesting it? Has the management done acquisitions in the past at high valuations and did they work out successfully? (Check goodwill write-offs) . Has the management used aggressive accounting in the past to manage results? www.safalniveshal.com Page 3 of 8The Safal Niveshak Mastermind ‘Module 6 | Lesson 43 9. 10. uu. 12. Does the management make more than 3% of net profit as salary? Has the management been reprimanded by SEBI or other bodies. Does the management have a bad governance history with other firms? (check watchoutinvestors.com) Does the company have opaque transactions with subsidiaries (check relatéd party) and are transaction sizes big? How many members of the promoter or family part of the Board of Diréetors? Does the family perform any useful role in management? Has the management pledged more than 20% of shares? If yes, why? Have the managers been buying or selling the stock? V. Sensible Price Tag 1 2. 3. 4 5. Does the company sell at PE > 20x? Does the current valuation assume growth in excess of the pastor the same as past above average growth? Does the company sell at huge discount to market or td othér companies in the industry? Why? Is the stock selling at 20-30% discount to your intrinsic value estimates as per the DCF model? Is the market expecting a fast growth in earning going forward as per Stephen Penman’s Residual Earnings Model? VI. Psychological Checklist 1 10. uu. 12, 13. Social proof: Is this stock held by someone Tike or admire and overoptimistic about it (not objective)? Sunk cost fallacy: Have I held the stock for a long time and hence not ready to change opinion? Is there performance envy involved?)Others have done well with this idea and Ihave missed out on the gain? Authority bias: Is this stock held by other investors I like and admire and is that influencing me? Availability bias: Have Peonsidered non annual report data, industry data and overall trends or only'fdcussing on easily available information? Recency bias: Am giving more weight to recent data (check if the projections based on recent data of averages / look at 10-12 yrs data) Confirmation ‘bias: Have I checked for a similar company with identical economics which has not done well (in same and different industry). If yes, why did it notdo well? Am I too overconfident on the situation - assuming over-familiarity , associating positive unrelated feeling, too high weight to optimistic scenario ( familiarity due to work / association with the industry ) Have done probability analysis for all negative factors Am Thaving too much loss aversion — over-weighing negative factors? Consistency bias: Am I slow in changing opinion — not responding to negative news? . Have I looked at the base case for the industry — Have majority of the companies in the industry created wealth? Status quo bias: Am I unwilling to sell existing holding? www.safalniveshal.com Page 4 of 8The Safal Niveshak Mastermind ‘Module 6 | Lesson 43 Charlie Munger’s Investing Principles Checklist Peter Kaufman has done an amazing job compiling some of the world's best lessons on investment behaviour into a masterpiece. We know it as “Poor Charlie's Almanack*, which is a collection of speeches and talks by Charlie Munger. While the entire book is one amazing journey through the mind of one the greatest investment and behavioural thinkers of our times, one part that takes the cake is where Kaufman has condensed Munger’s teachings into a checklist. He calls this “Investing Principles Checklist”, as it contains the core prinéiples that have made Munger the brilliant investor he is today. These principles can further be condensed into four most basic guiding principles of life and investing - Preparation. Discipline. Patience. Decisiveness. These principles cannot be prioritized in terms of any importafi¢e) Rather, together, they make up a sensible, thinking, and disciplined investor's mental toolkit. 1. Risk - All investment evaluations should begin by measuring risk, especially reputational. ‘+ Incorporate an appropriate margin of safety Avoid dealing with people of questionable character Insist upon proper compensation for risk assumed Always beware of inflation and interest rate exposures Avoid big mistakes; shun permanent capital loss Independence - “Only in fairy talés areemperors told they are naked.” ‘© Objectivity and rationality requireindependence of thought » Remember that just because other people agree or disagree with you doesn’t make you right or wrong - the only thing that matters is the correctness of your analysis and judgment * Mimicking the herdvinvites regression to the mean (merely average performance) 3- Preparation - “Ihe only way to win is to work, work, work, work, and hope to have a few insights.” * Develop into) a lifelong sclf-learner through voracious reading; cultivate curiosity and strive to become a little wiser every day More important than the will to win is the will to prepare Deyelop fluency in mental models from the major academic disciplines If you want to get smart, the question you have to keep asking is “why, why, why?” 4. intellectual humility - Acknowledging what you don’t know is the dawning of wisdom. ’ Stay within a well-defined circle of competence * Identify and reconcile disconfirming evidence ‘* Resist the craving for false precision, false certainties, ete. www.safalniveshal.com Page 5 of 8The Safal Niveshak Mastermind ‘Module 6 | Lesson 43 + Above all, never fool yourself, and remember that you are the easiest person to fool * “Understanding both the power of compound interest and the difficulty of. getting it is the heart and soul of understanding a lot of things.” 5. Analytic rigor - Use of the scientific method and effective checklists minimizes errors and omission: ‘* Determine value apart from price; progress apart from activity; wealth apart from size It is better to remember the obvious than to grasp the esoteric Be a business analyst, not a market, macroeconomic, or security’analyst Consider totality of risk and effect; look always at potential second order and higher level impacts «Think forwards and backwards ~ Invert, always invert 6. Allocation - Proper allocation of capital is an investor's number one job. * Remember that highest and best use is always measured by the next best use (opportunity cost) * Good ideas are rare — when the odds are greatly in your favor, bet (allocate) heavily * Don't “fall in love” with an investment)'=) be situation-dependent and opportunity-driven 7. Patience - Resist the natural human bias tolaet. * “Compound interest is the eighth wonder of the world” (Einstein); never interrupt it unnecessarily Avoid unnecessary transactional taxes and frictional costs; never take action for its own sake © Be alert for the arrival of luck Enjoy the process along with the proceeds, because the process is where you live 8. Decisiveness -Whén_ptoper circumstances present themselves, act with decisiveness and conviction. Be fearful when others are greedy, and greedy when others are fearful * Opportunity doesn’t come often, so seize it when it comes * Opportunity meeting the prepared mind; that’s the game 9. Change - Livewith change and accept unremovable complexity. © Recognize and adapt to the true nature of the world around you; don’t expect it to adapt to you Continnally challenge and willingly amend your “best-loved ideas” Reeognize reality even when you don’t like it — especially when you don’t like it 40. Focus - Keep things simple and remember what you set out to do. » Remember that reputation and integrity are your most valuable assets — and can be lost in a heartbeat ‘+ Guard against the effects of hubris (arrogance) and boredom www.safalniveshal.com Page 6 of 8The Safal Niveshak Mastermind ‘Module 6 | Lesson 43 * Don’t overlook the obvious by drowning in minutiae (the small details) Be careful to exclude unneeded information or slop: “A small leak can sink a great ship” ‘+ Face your big troubles; don’t sweep them under the rug In the end, it comes down to Munger's most basic guiding principles; his fundamental philosophy of life: Preparation. Discipline. Patience. Decisiveness. A “Less is More” Checklist I believe rather than obsessing with the bewildering fusion of news/€nd noise, you should concentrate on a few key elements in stock sele , broadly, what are the 5-10 most important things you should know about any busingssyow are about to invest in? Of course, if I knew the exact answer I would have retired long ago! Even if I could know all the facts about an investment, I would not necessarily profit. This is not to say that fundamental analysis is not useful. It certainly is. But information generally follows the well-knowm80/20 rule: the first 80% of the available information is gathered in the first 20% of the time spent. So if I were to list down a very few questions\that, I believe, would help me do an 80% analysis of a business, they would be,., 1. Is the business simple to understand and run? (Complex businesses often face complexities difficult for its managers to get over) 2. Has the company grown its sales and EPS consistently over the past 5-10 years?(Consistency is mofe important than speed of growth) 3. Will the company be-around and profitably better in 10 years? (Suggests continuity in demand for the company’s produets/services) 4. Does the company have a sustainable competitive moat? (Pri margins, lead over competitors, entry barriers for new players) 5. How good is the management given the hand it has been dealt? (Capital allocation, return on equity, corporate governance, performance against competition) 6. Does theeompany require consistent capex and working capital expenditure to grow its business? (Companies that have to spend continuously on such areasiare like running on treadmills, which is not a good situation to have) 7. Does. the company generate more cash than it consumes? (Cash generators have a higher probability of surviving and prospering during bad economic situations) 1g Power, gross Overallpby building your own checklist — a standardized set of questions you must answer before you commit to any investment decision — you can reduce the risk of making costly errors. The best way to do that is by looking at your past mistakes. www.safalniveshal.com Page 7 of 8The Safal Niveshak Mastermind ‘Module 6 | Lesson 43 Exercise Pull out your “Diary of a Dumb Investor” and write down the above-mentioned checklists in it. It’s very important to write down the checklist by hand (instead of taking prints of the same), because you would remember more when you write down stuff. Further Reading « The Investment Checklist ~ Michael Shearn * The Checklist Manifesto: How to Get Things Right ~ Atul(Gawande * Rohit Chauhan’s Investment Checklist Disclaimer: This document is confidential and is supplied to you for information purposes only. 1 should not (iretly oF Indirectly) be reproduced, further distributed to any person or published, in waole or in part, for any purpose whatsoever, ‘without the eonsent of Skylab Media & Research, This document docs not constitute a personal recommendation or tale into account the partieular investment objectives, Snanchl situtions, of needs of individual investors. www.safalniveshal.com Page 8 of 8