Investment checklists and dealing with contradictory information

Many of the great value investors use investment checklists while screening out investment opportunities. Using checklists for initial screening is a widely accepted and popular method.  The beauty of checklists is that they can be used for a wide range of things (not just investing). I recommend a great book on the subject written by Atul Gawande called The Checklist Manifesto.

One of the challenges equity analysts and investors face  is contradictory information on the checklists. What I mean is that, no single company will have everything positive going for it. There will always be certain factors that will be less than ideal.

Let us take a theoretical situation where we are judging a company on the basis of governance, profitability, growth, economy in which they run, competitive environment etc. The most likely case is that the company will not rate highly in these factors. A couple of the factors like economy and competition is also beyond the company’s control. What this means for any investor is that, before investing they will have to have trade-offs not only on these qualitative and quantitative factors but also when comparing with valuations.

Here are two things I recommend to work around this problem.

Have a list of deal-breakers

While screening a few things are deal breakers for me. Bad governance is definitely the number one deal breaker because I think the value of a minority share in a badly governed company is ZERO. Inability to generate returns equal to cost of capital over an entire business cycle is another one. Extremely irrational competition (e.g. price wars with no end in sight) or regulatory pressures (taxes being raised to finance growing budget deficit) can also be deal breakers. Sometimes, economic health can put the country in a no-invest zone. Russia or Argentina at present moment can be an example.

What this exercise does is clearly set situations where we are not willing to compromise.

Compare the negatives with the potential upside

For all other negatives (that are not deal-breakers) like a sudden increase in competition, an increase in raw material price reducing margins etc we have to compare them with upside derived from our fair value model. If our forecasts already account for these negatives then they are already accounted for. If the situation is binary and it is difficult to quantify the impact then we might need to resort to other qualitative judgments (compare the risk vs the upside).

In conclusion, the reason for writing this post is to add to my existing blog posts on why investing is a fairly complicated thing. It perennially involves looking at multiple factors, understanding probabilities and dealing with uncertainties. There are no perfect investments and no perfect methods for generating massive returns.

 

Asif Khan, CFA

Asif Khan is presently a Research Analyst (Financial Sector) for Exotix which is a frontier market focused investment bank. He has more than 6 years of work experience as equity analyst in both buy and sell side roles across Asian frontier markets. Asif is a CFA Charterholder and has a dual major in Finance & Economics from North South University.

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