March 12, 2017

Investment Checklist: The Art of Indepth Research


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I’m often times asked, “What books do you suggest I read?” One book that I recommend is Michael Shearn’s The Investment Checklist: The Art of In-depth Research.

Many value investors use checklists as part of their investment process.  Perhaps the most notable is Monish Pabrai, whose long-only equity fund has returned a cumulative 517% net to investors vs. 43% for the S&P 500 Index since inception in 2000[i].  He, like many others, became interested in the topic after reading Gawande’s Checklist Manifesto, which discusses the life saving benefits of checklists in an operating room or the cockpit of an airplane.  As applied to investing, the benefits include a deeper understanding of the company being analyzed, its customer base, and the competitive environment.  This allows the investor to better estimate the value of the company and to quickly assess new information and determine if the stock reaction to the news is creating an opportunity (to buy or sell).

Appreciating the merits of a checklist (Bill and I included one in the final chapter of Why Stocks Go Up and Down), I set out to identify a book that I could use to refine my existing list.  Of the books currently available, The Investment Checklist: The Art of In-Depth Research looked most promising.  The book is organized into 11 chapters.  The first three chapters stress the importance of understanding the business.  In Chapter 4, readers learn to assess the industry dynamics and competitive environment before evaluating the quality and fundamentals of the business itself in Chapters 5 and 6. Chapters 7-9 are devoted to evaluating the management team.  The book concludes with two chapters dedicated to assessing the company’s growth opportunities.

Frankly, I bought the book with the intention of skimming a few chapters before turning to the end of the book to review the aggregated list, looking for items I could use to supplement my own list.  But as I began reading the book, I was drawn in by Shearn’s insightful comments and references to companies that I’ve held or currently hold.  As an example, in Chapter 3, he stresses the need to understand a company’s core customer base.  He uses Whole Foods Market to demonstrate how this knowledge can help investors improve their decision making:

“The management team at Whole Foods Market believed that 75% of purchases were made by 25% of the customers who shopped exclusively at the store.  My firm conducted its own due diligence by speaking with customers, suppliers, customer demographic information services, and competitors, and we learned that this was generally true.  This information helped us to buy the stock when the economy entered into a recession in 2007 and the stock price dropped from $37 per share at the beginning of 2008 to as low as $8 per share in November 2008.  At the time, many other investors believed that Whole Foods Market was a high-priced grocer and that its customers would abandon the store in search of lower prices.  However, because we had taken the time to understand the core customer of the business, we believed these core, loyal customers would not move to competitors, but instead they might simply decrease the number of items they purchased. Within a year, we got confirmation of this, as Whole Foods Market disclosed that sales had not dropped as much as investors had anticipated, and the stock price recovered to more than $30 per share.”  Subsequently, the stock rose to over $100 per share before the company authorized a 2 for 1 stock split in May 2013.

At 363 pages, the book provides ample discussion around the various checklist items.  More importantly, Shearn uses countless examples like the one above to help readers understand and apply the most important concepts.  I don’t know that I’ve read another book that so effectively uses real-world examples to reinforce the topics discussed.  For these reasons, the Investment Checklist: The Art of In-depth Research would be a good book for analysts and others entering the investment industry.  It would also be a good primer for graduate and undergraduate students taking courses in investment analysis.  In fact, I would go so far as to say that if I were teaching another investment research course, this book would be a required read.

 

[i]DeMuth, Phil. How Mohnish Pabrai Crushed the Market by 1100% Since 2000. Forbes, Sept 23, 2013

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