Finance author Tim Richards is recommending a checklist-based stock-picking strategy for investors, and the more I think about it, the better the idea becomes. Not only does a checklist promote discipline and careful analysis, it also helps avoid dumb mistakes, which could be the most important skill in investing. Berkshire Hathaway's Charlie Munger once noted "It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent."
Mr. Richards produces the criminally underrated Psy-Fi investor web site in addition to his books. In a recent post , he writes, "the checklist is a powerful tool for investors, largely because it can be customized to the individual… The checklist allied to a method of obtaining truthful feedback.. is probably the best we can hope to achieve at our current level of knowledge."
Mr. Munger's business partner Warren Buffett probably doesn't adhere to a strict checklist at this point, but it's not difficult to imagine one based on his investing success. Mr. Buffett emphasizes long-term cash flow generation and values consistency above all things, so his list would start with something like 'low standard deviation of ten- year positive free cash flow growth'.
Berkshire Hathaway investments also require a "competitive moat" – a competitive advantage that protects market share and provides the ability to raise prices. Historically, this has often come in the form of a strong brand name, like Gillette or Budweiser, but has also taken different forms. The company invested in railways in part because new rail capacity wasn't being built, and this scarcity provided existing companies with strong pricing power.
Mr. Buffett also demands strong management teams so the checklist would also include a measure of profitability to gauge the CEO's ability, something like return on equity or return on assets ( depending on the industry) relative to competitive firms.
Crucially, Berkshire Hathaway won't buy stocks trading at high valuation levels so the final box on our cursory checklist would be a price-to-earnings ratio (or other relevant valuation measure) lower than the 10-year average.
An investor using this checklist would not buy a stock unless all of the conditions were met. This is the way it enforces discipline, and helps dodge stocks that can torpedo portfolio performance. As Mr. Richards noted in the original blog post, the technique is flexible and can be adjusted over time to suit each investors' preferences.
The checklist technique is also flexible by investing style. The hypothetical framework above might suit conservative investors, but more risk tolerant market participants can generate their own list. For instance, a momentum strategy checklist wouldn't have a box for attractive valuation levels, but would include stock price strength, analyst earnings revisions and earnings growth.
The one relatively minor downside to checklist investing is that it initially might create too much discipline, and investments that don't make the cut turn out to be highly profitable. Over time, however, the criteria can be adjusted and I can't see a downside for using checklists over the mid and longer term. I like the idea enough that I am now committed to developing checklists of my own.