Investing isn't easy. Most investors far underperform a basic index fund, and the reasons are often simple errors that, in hindsight, were obvious and should have been avoided.
I recently sat down with an investing great who uses an innovative approach to minimize errors. If you've read the book The Checklist Manifesto by Atul Gawande, you might remember a mention of value investor Mohnish Pabrai as someone who "incorporates formal checklists into" his work. Gawande wrote:
He [Pabrai] did very well ... but not always, he found. He also made mistakes, some of them disastrous.
These were not mistakes merely in the sense that he lost money on his bets or missed making money on investments he'd rejected. Risk is unavoidable in Pabrai's line of work. No, these were mistakes in the sense that he had miscalculated the risks involved, made errors of analysis.
So now Pabrai has a checklist that he ticks off before committing to an investment, similar to how a pilot checks off a list of variables before takeoff.
I asked Pabrai to explain more of the investing checklist. Here's what had to say. (Transcript follows.)
Morgan Housel: It's well known that you use a checklist in your investing process. Can you just give me an overview of how that came about?
Mohnish Pabrai: Sure. I think after I got my head handed to me in 2008, the funds were down 60%; I think one of them was more than 60% in 2008, and the markets were down 38% or so, so we underperformed the markets by some margin in 2008. And of course one of the reasons we were fully invested, and I think we also had some mistakes that became quite apparent when the tide went out, so to speak.
So I did a lot of soul searching on what I was missing, and I happened at the time to read a book by Atul Gawande; actually, I read an article first in The New Yorker, which was on the checklist, where he applied it to the medical field, and then subsequent to that, I had conversations with Atul, and he actually made it into a book called The Checklist Manifesto, which is a wonderful book.
But basically what the "a-ha" moment that came about for me was that I looked at the way the FAA functioned, the Federal Aviation Administration, and the FAA basically -- many will defer to it as a death agency because what it does is, on a day-to-day basis, the agency does almost nothing. At least to the outside world it looks like they're doing hardly anything. But whenever there's a plane crash pretty much anywhere in the world, the FAA goes into overdrive and they work with the NTSB, local authorities, and the plane manufacturers to get to the bottom of exactly what went wrong. What was the cause of that crash?
After they figure out the exact cause of the crash, they then work on figuring out how could this crash have been prevented? Could there be some design change or procedure change or training change which would have avoided this crash? And they go one step further where they actually calculate the future loss of life that would happen if they did nothing because of that issue. And the FAA has a definition of what a human life is worth. Last time I checked, you and I were worth about $3.5 million, according to the FAA. It goes up every year; it's indexed to inflation. It might be up to $4 million now.
And so they will say, OK, a particular issue may cause 100 lives to be lost in the next 10 years, so that would be like a 350 or 400 million-dollar loss, and they will come up with suggestions for the industry which would be below that number. So it is a very pragmatic approach to making flying safer. And actually the end result is that flying is extremely safe. Not only is it extremely safe, it's extremely cheap.
If you contrast what the FAA did with the nuclear industry, the nuclear industry took an approach which said you can never lose a human life, and that human life is worth infinity. And the end result is we haven't built a nuclear plant in 20 years, and Japan is shutting down all its plants. In fact, the Japanese case is quite interesting, because not a single person has died because of the nuclear incident in Japan as a result of the tsunami, even today. They have had zero life lost, and it's unlikely there'll be any significant elevation of cancer rates and all of that, but there's paranoia. And so you ended up with zero lives lost, but the shutdown of an industry in a country which has no internal energy source. It's quite remarkable.
So anyway, I'm a fan of the FAA approach to looking at life and doing things, and not the extreme nuclear industry approach, and so when I developed my checklist, I said why don't we just copy what the FAA does and apply it to investing? So what I said is that the equivalent of a plane crash in investing is when someone has a permanent loss of capital, right? That's, your plane just crashed, OK? With your permanent loss of capital.
And I said, why don't we look at the best investors in the world, because these are some great minds, and look at investments where they ended up with a permanent loss of capital, and then evaluate the reason why that loss happened. The other thing to look at is that was it apparent before the investment was made that it was likely to lose money? Was it apparent or not? And so I started to study; I clearly studied my own mistakes, because I have already owned those, and I went back systematically and documented why we lost money on these different investments. Then I looked at Warren Buffet's mistakes, Charlie Munger's mistakes, LongLeaf Partners, Third Avenue, and so on, all the great investors.
And what was stunning to me is that in almost all cases where I could figure out the reason for the loss, it was very apparent before the investment was made, number one. And the second is the reason was very basic. It wasn't some esoteric reason that you had to do some higher math to the fifth decimal to figure out this wasn't going to work. It was very basic.
I started to make a list of questions. So for example, Berkshire Hathaway lost money on Dexter Shoes, when they bought Dexter Shoes. A question that comes up on the checklist is, is this business a business that can be affected negatively by foreign competition? Can it be affected negatively by low-cost labor in other countries? Those came out of, for example, the Dexter Shoes example.
I looked at his U.S.A. [unclear], which actually he made money on in the end, but it was a pretty traumatic experience for Warren. And again, in the airline business there's the obvious factors where you do not control the actions of your dumbest competitor, who determines your price. All your fixed costs are upfront and you're buying from a duopoly. All your maintenance costs are with the duopoly. You're either going to go to Boeing or GE to have all your engines serviced. Your cash flows, you have no control over them because it's determined by your dumbest competitor, so the combination of all of that will always make the airline business really tough. It's a tough business to be in. So those things become obvious when you look at does the business have pricing power? And does the business have high fixed costs and high capital expenses and is it unionized? All those sorts of things come up from the U.S. Air example.
And so I went through business by business, and we today have I think about 97 or 98 questions on the checklist, and it doesn't take very long to go through it. I think when I look at a business and I run the checklist, it might take 15, 20 minutes to run through it. And they do fall into broad categories. So for example, we have a set of questions which relate to leverage. Debt covenants, how levered and all kinds of different issues related to leverage, because that has caused a lot of investments to go south.
We have another set which relates to moats, the lack thereof, right? And so all kinds of things. There's another set of questions which relate to things like unions and labor relations. There's another whole set of questions on management and ownership. Just all kinds of nuances of whether they own stock, do they act like owners and all those sorts of things that come up. And then there are a few miscellaneous ones.
So it's actually worked out remarkably well. Since I put the checklist in place, in 2008 till today, we have made I think more than 30 different investments in the last five years or so. We only have so far, we invested about $200 million. We've already exited a bunch of positions and we've exited with about $500 million on those positions, and we only lost money on two investments. And the total amount of money we lost from those two investments is less than 5 or 6 million dollars. And I think a large part of that is the checklist significantly brought down the error rate.