Optimism abounds in the capital markets. They are full of people who either 1) have an interest in selling you on the prospects of a security or 2) are genuinely optimistic about a company’s future but hold a biased perspective. It is helpful to have a checklist to make sure that you are being as objective as possible to guard against developing behavioral biases after being inundated with one-sided views. Before you succumb to the charms of a charismatic management team or fall for someone pitching you on another “story stock,” read the skeptic’s checklist. It won’t give you all the answers, but it will give you a fighting chance against the biases that you are likely frequently exposed to.

1. Do I understand this business well enough to approximately estimate its key economic characteristics in 5 to 10 years?

This was Warren Buffett’s response to my question at a group dinner 15+ years ago about what things he looks for before he invests in a company. Valuation (no matter how it is done), necessitates estimating a company’s future prospects. If you cannot understand the business well enough to predict its long-term economic outcome in a narrow enough range to be useful, then how can you have a meaningful opinion on whether this company is undervalued?

2. How strong is the company’s competitive advantage? Is it getting stronger or weaker?

A strong competitive advantage makes the business more predictable long-term. It also increases the odds that the company can sustain above-average economic characteristics. Investors too frequently get excited about the financial details without first stepping back and understanding if there is anything special and sustainable about the company that is likely to allow it to maintain or exceed the current level of performance.

3. What would it take for this company to be out of business in 10 years?

This exercise focuses your mind on what can go wrong and how wrong it has to be to lead to business failure. Some companies are more fragile than others. Some companies are nearly indestructible – almost nothing can sink them. Others rely on events taking a certain path or on getting lucky with a key product or trend for their success. If it is difficult to find a reasonable answer to this question, that’s a good sign.

4. What would it take for this company to have profits below their current level in 5 years?

Analysts rarely model companies to have declining profits short of the most obvious cases where the business is already in decline. The typical Wall Street forecast for long-term growth is approximately twice the realized rate, in no small part due to a substantial minority of outcomes having declining long-term profitability. Answering this question will get you to think about a more realistic negative scenario than the last question.

5. How much time and capital would it take for someone (e.g. a competitor or a new entrant) to turn this into an economically unattractive business?

The best businesses are very hard to ruin no matter how much someone tries. Investors need to guard against adverse change to a company’s economics. The best defense is a combination of a strong competitive advantage with a management team committed to strengthening it over time. If this thought exercise helps you uncover that it wouldn’t take much to cause the company to become an unattractive business – beware.