Search out "Patterns" of mistakes & failures - Put a few checks in place?

Lessons from Mr Market
1

Why we fail at what we set out to do in the world?

Much of the world and universe is - and will remain - outside our understanding and control.

But in the realms, where control is within our reach, we have just 2 reasons the we may still fail. The first is** Ignorance.** The second type of failure Guru’s call Ineptitude )- because in these instances the knowledge exists, yet we fail to apply it correctly:(

Checklists seem to provide protection against such failures. They remind us of the minimum necessary steps and makethem explicit.They not only offer the possibility of verification but also instill a kind of discipline for higher performance.

Gaurav Sud and Abhishek BasuMallick (avid checklist practitioners) have been the inspiration behind starting this thread - to help us evolve our own strategies of overcoming failure.

I am asking them to start the boll rolling, others like us can pick it up from there and start running:). We should be able to come up with refined checklists, eventually.

Abhishek has long been canvassing support on using checklists. He even provided a list in our Capital Allocation Framework thread - couldn’t catch the inherent power of it - I reason my happy-go-lucky attitude/luck had always taken care of me - never felt the pinch - soI sort of trivialized it:(

Just want to share how Gaurav caught my attention in our last Gujarat trip - He said - “Ever wondered why Airplanes are the riskiest mode of travel, but have the lowest number of casualities?” )- there is an answer - it will seem almost ridiculous in its simplicity. It is a checklist!

Caught your attention? There, for more read up on The Checklist Manifesto )- Atul Gawande.

Now, we have an opportunity before us.

Eventhe most expert among us can gain from searching out the patterns of mistakes and failures and putting a few checks in place. But will we do it? Are we ready to grab onto the idea?

Let’s get started. Over to you Gaurav and Abhishek

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Thanks Donald for starting this. In terms of my genesis on Checklists my introduction to it was driven by this presentation given by Mohnish Pabrai on using checklists. The whole concept was so simple but at the same time so powerful that it was an eye opener

http://www.gurufocus.com/news/120101/how-mohnish-pabrai-uses-checklists--presentation

Coming to the success of checklists used by Airlines for the high safety record, here are some issues submitted by pilots after running the checklist and the solutions recorded by maintenance engineers

Pilot: Left inside main tire almost needs replacement.

Engineers: Almost replaced left inside main tire.

Pilot: Something loose in cockpit.

Engineers: Something tightened in cockpit.

Pilot: Dead bugs on windshield.

Engineers: Live bugs on back-order.

Pilot: Evidence of leak on right main landing gear.

Engineers: Evidence removed.

Pilot: Suspected crack in windshield.

Engineers: Suspect you’re right.

Pilot: Number 3 engine missing.

Engineers: Engine found on right wing after brief search.

Pilot: Aircraft handles funny.

Engineers: Aircraft warned to straighten up, fly right, and be serious.

Pilot: Mouse in cockpit.

Engineers: Cat installed.

Pilot: Noise coming from under instrument panel. Sounds like a midget pounding on something with a hammer.

Engineers: Took hammer away from midget

Jokes apart, to seed the discussion and keep things simple what we would prefer is to discuss one checkpoint at a time. We can discuss the merits or futility of the same and then move on to the next point.

The key point is that everyone should make their own checklists, as each may attach more importance to one checkpoint over other. But overall it becomes a good starting point for researching a stock idea deeper.

To seed the discussion let me start with 2 basic points that I have in my mind when I come across any idea

  • Does the company pay any DIVIDEND? If yes then what is the payout ratio? Has the dividend been increasing over time?
  • Does the company pay any Taxes? If yes then what is its percentage of PBT? If the Tax rate is 20% what are the reasons for the same?

The basic rule that I follow is that if the company is not paying dividend I will not invest in it. Again if the company is not paying significant taxes then until unless there is a clear cut explanation I will ignore the idea no matter how good the other things look.

Following such checkpoints may make me miss a big return idea but that really does not bother me. Better safe than sorry…

Gaurav

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I have a very basic checklist that I try and use and also try and expand with time.

The way I have tried to structure it is:-

  1. Business Questions
  2. Financial Questions
  3. Valuations
  4. Risks
  5. Past Mistakes (this is where most of the addition goes in)

Business Questions

  • Describe the business in a few sentences. What does the company do? Who are its primary customers?
  • Is the sector that the company is in growing? i.e. Is there a headwind or a tailwind present?
  • What is the current market share of the company? Can the market share be increased?
  • Who are the primary competitors? Why is this company a better investment than them?
  • What is the ownersâ and managementsâ stake in the company?

Financial Questions

  • How much debt is there in the balance sheet? Is it increasing, decreasing or remaining constant?
  • Is the debt level normal for the sector the company is operating in (i.e. how much is the debt-equity ratio of its nearest competitors)?
  • How much cash is there on the BS? What is the cash per share?
  • Is the Networth rising over the years?
  • Is the inventory/sales rising or more-or-less in the same range? [Rising ratio may mean company is not able to sell its products.]
  • Is the debtors/sales rising or more-or-less in the same range? [Rising ratio may mean company is not able to collect payment.]
  • Has the company increased its sale, net profit, operating margins and net margins over the years?
  • Has the company increased it RoE, RoCE, (RoA for financial companies) over the years or atleast maintained it? How does it compare to its competitors?
  • Has the EPS growth over the years kept pace with sales/profit growth? (Impact of dilution)
  • Is the company operating cashflow positive? Is the operating â investment cashflow positive? Is the company net free cashflow positive?
  • Does the company pay tax, dividends every year?

**
Valuations**

  • What is the expected valuation based on DCF, EPS growth, Grahamâs formula?
  • Is the PE ratio below 15? Is the PEG above 1.0?
  • Why do you think the stock is under priced? Is there an expectation to double the investment in 2-3 year timeframe? If not, why bother?
  • What has been the share price over the last 5 years? Has it matched the profit growth? If not, why not? Does the market know something I donât?

Risks
)-----

  • What will happen if the interest rates go up (or down)?
  • What will happen if there is cheap import (from China or somewhere else)?

Rules of thumb (Be very very careful if you are planning to violate any of these principles)
â P/E should be less than 15
â P/B should be less than 3
â RoE/RoCE should be above 25% OR growth above 25%
â Be very very selective when Sensex/Nifty PE goes above 22

Past Mistakes

â Companies with lot of foreign currency borrowing in a depreciating currency environment â FCCBs/ ECBs can spell disaster (e.g. Sintex)
â Getting into commodity businesses where there is no pricing power (e.g. Hira Ferro).
â Buying a cheap stock without any likely catalyst (stock can remain cheap for a long time) (e.g. Lloyd Engineering).
â Great businesses do not necessarily make a great stock. Great entry price (cheap) makes a great stock. (e.g HLL in 2000)

View invited…I am always looking to improve on the checklist (and hopefully not to add on to my mistakes!!)

4

Hi Guys,

Yes, checklist is very important because usually when we are into a stock and the price is doing well, we stopfocusingon the in-depth analysis again and this is when we may get trapped.

This is one of the main reason for starting www.screener.in, wherein we are trying to automate some of the checklist point and hence list out Pro & Cons.

Some important things I consider while looking at a stock are:

1). The past track record in terms of growth in sales. If the company is of less than 500 Cr size and not growing at 15% over last 3 years, then it may not worthwhile. In Indian context, growth is very important.

2). ROCE over last 3-5 years. If below 15% - avoid. Get excited on cos with ROCE of 25%+.

3). Tax Pay-out. If less than 15% be suspicious until n unless a solid reason. Prefer cos with 25%+ consistent tax provision.

4). Div Pay-out ratio - avoid cos with no dividend and a good co is with div payout of more than 15%.

5). Keep a check on Inventory and debtor days over the years. If a business has more than 25% in both inventory and debtors, be very careful. Working capital shouldn’t be more than say 35% of turnover.

6). Promoter Holding. Anything below 35% is negative.

7). Debt Equity ratio should be below 1.5 and max 2.

8). Also check interest provided as % of debt. At times, cos are capitalizing the interest or issuing convertible bonds etc and hence reporting higher profits.

9). Avoid cos which sound too high tech and flashy. If you can’t understand the business they are doing, better avoid.

10). Avoid cos doing frequent acquisitions or having lots of foreign operations.

11). Avoid cos which keep diluting their equity or keep changing the same. Usually these are the traps. Best cos are which don’t need money from investors for long.

12). Avoid cos with both cash and debt on balance sheet for sometime.

Ayush

PS: I think a better way might be picking up good points and summarizing at a place. If someone finds new point to be added, it should be discussed and added. This will avoid duplication and maintain interest and reference point.

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No activity in this thread since long time. Now that a year or so has passed since we discussed this. Request members to share more on there recent failures :slight_smile:

6

you can add these checks as well

Excise duty/ Gross Sales(Normally-8%). The best way i have come across so far. My practice as banker tells me that prudent people do pay excise duty, since excise officers visit every month regularly :).

Contingent Liabilities vis a vis profits: include off-bs items like l.c.'s as they tell you the whole story

Related Party transactions as a % of sales: nothing much to add here.

7

I think promoters holding is below 50% , then avoid it.