The Checklist Manifesto_ How to Get Things Right - Atul Gawande [67]
So Pabrai made a list of mistakes he’d seen—ones Buffett and other investors had made as well as his own. It soon contained dozens of different mistakes, he said. Then, to help him guard against them, he devised a matching list of checks—about seventy in all. One, for example, came from a Berkshire Hathaway mistake he’d studied involving the company’s purchase in early 2000 of Cort Furniture, a Virginia-based rental furniture business. Over the previous ten years, Cort’s business and profits had climbed impressively. Charles Munger, Buffett’s longtime investment partner, believed Cort was riding a fundamental shift in the American economy. The business environment had become more and more volatile and companies therefore needed to grow and shrink more rapidly than ever before. As a result, they were increasingly apt to lease office space rather than buy it—and, Munger noticed, to lease the furniture, too. Cort was in a perfect position to benefit. Everything else about the company was measuring up—it had solid financials, great management, and so on. So Munger bought. But buying was an error. He had missed the fact that the three previous years of earnings had been driven entirely by the dot-com boom of the late nineties. Cort was leasing furniture to hundreds of start-up companies that suddenly stopped paying their bills and evaporated when the boom collapsed.
“Munger and Buffett saw the dot-com bubble a mile away,” Pabrai said. “These guys were completely clear.” But they missed how dependent Cort was on it. Munger later called his purchase “a macroeconomic mistake.”
“Cort’s earning power basically went from substantial to zero for a while,” he confessed to his shareholders.
So Pabrai added the following checkpoint to his list: when analyzing a company, stop and confirm that you’ve asked yourself whether the revenues might be overstated or understated due to boom or bust conditions.
Like him, the anonymous investor I spoke to—I’ll call him Cook—made a checklist. But he was even more methodical: he enumerated the errors known to occur at any point in the investment process—during the research phase, during decision making, during execution of the decision, and even in the period after making an investment when one should be monitoring for problems. He then designed detailed checklists to avoid the errors, complete with clearly identified pause points at which he and his investment team would run through the items.
He has a Day Three Checklist, for example, which he and his team review at the end of the third day of considering an investment. By that point, the checklist says, they should confirm that they have gone over the prospect’s key financial statements for the previous ten years, including checking for specific items in each statement and possible patterns across the statements.
“It’s easy to hide in a statement. It’s hard to hide between statements,” Cook said.
One check, for example, requires the members of the team to verify that they’ve read the footnotes on the cash flow statements. Another has them confirm they’ve reviewed the statement of key management risks. A third asks them to make sure they’ve looked to see whether cash flow and costs match the reported revenue growth.
“This is basic basic basic,” he said. “Just look! You’d be amazed by how often people don’t do it.” Consider the Enron debacle, he said. “People could have figured out it was a disaster entirely from the financial statements.”
He told me about one investment he looked at that seemed a huge winner. The cocaine brain was screaming. It turned out, however, that the company’s senior officers, who’d been selling prospective investors on how great their business was, had quietly sold every share they owned. The company was about to tank and buyers jumping aboard had no idea. But Cook had put a check on his three-day list that ensured his team had reviewed the fine print of the company’s mandatory stock disclosures, and he discovered the secret. Forty-nine times out of fifty, he said, there’s nothing to be found. “But then