This is a follow on post to “Why we fail” that examines the reasons we fail, in general and investing in particular. This post suggests a simple yet powerful concept that will improve your investment process and therefore, performance over the long-term.

Oct 30, 1935 Wright Airfield, Dayton Ohio:

The US Army Air Corps was conducting a flight competition to build the next-generation long-range bomber. Based on early evaluations, Boeing’s aluminium alloy model 299 was expected to come out ahead by a distance compared to those of competition. The Model 299 could carry five times as many bombs as the army had requested, could fly twice as further and was faster than any previous bomber. With a wingspan of 103 feet and four engines jutting out from the wings, it was already nicknamed “Flying Fortress”.

The competition was expected to be a formality and the army had already planned to order 65 of the Model 299. A small crowd of top army brass and manufacturing executives watched as the sleek and impressive machine taxied onto the runway, piloted by veteran pilot and the Army corps chief of flight testing, Major Ployer P. Hill.

With the all-clear, the majestic plane roared down the tarmac and climbed sharply to 300 feet. Then it stalled, turned on one wing, and crashed in a fiery explosion. Two of the five crew members, died, including Major Hill. The army declared the smaller Douglas model as winner and Boeing went nearly bankrupt.

Investigation revealed nothing mechanically wrong with the plane. Hill had forgotten to release a new locking mechanism on the elevator and rudder controls. With four engines, each with its own oil-fuel mix, retractable landing gear, wing flaps, electric trim tabs that needed adjustment to maintain different airspeeds, constant speed propellers with hydraulic controls, the conclusion was the Model 299 was too complex leading to ineptitude (the 3rd reason for “Why we fail“) on the part of the pilots. In short, it was “too much plane for one man to fly”

A lot of what we do today seems like that. Take investing. In addition to balance sheet and other financial statement analyses, there are concepts like value, contrarian, momentum investing, stock buybacks, rights issues, Federal Reserve action and many more. And no amount of reading Ben Graham’s “The Intelligent Investor” or Warren Buffett’s letters to shareholders seems to make the task of actually making investment decisions easier. In short, investing seems like too much plane for one man to fly, especially for new investors.

Handling complexity: Checklists

In spite of its failure at the flight competition, the army purchased a few Model 299s as test planes because some still felt they were flyable. They assigned a group of test pilots to figure out what to do with them. Instead of prescribing longer training for pilots, given the it was hard to imagine having more experience and expertise than Major Hill, they created checklists.

The pilot checklists were simple, brief and to-the-point, short enough to fit on index cards with step-by-step checks for takeoff, flight, landing and taxiing. By putting down the routine things that pilots already knew how to do, like checking that the brakes have been released, doors and windows are secured, pilots went on to fly the Model 299 for 1.8 Million miles without accident.

Think that your own job or investing is too complex to be reduced to checklists? The Model 299 example should certainly make you question that. Over time, with considerable trial and error, I’ve come up with my own “investing checklist” that I refer to before any buy decision. Note that this isn’t meant to cover the entire process of determining allocation to equities down to valuing and selecting a stock. Like “takeoff” or “flight” for pilots, effective checklists target specific activities, and this one tackles one where the abundance of information can lead to basic errors by investors.

This checklist comes into play after you have reason to believe that a company might be a potential investment, be it from the grapevine, from personal experience of using their products, their “dominant” position in their industry or other sources. Note: Getting a “hot tip” for a “counter” that has “moved up smartly” does not count as a basis for a potential investment.

The checklist approach to equity investing

1. Quality Management

Would you be comfortable doing business with the people running this company? Google the company founder (promoter) and the executive team.

Is the promoter still involved in the running of the company? Has his stake reduced significantly over the recent past?

Have there been recent top management exits? Mentions of accounting irregularities at previous organisations?

Is he typically seen on page 3 getting out of his Bugatti Veyron while the company shows 8 consecutive quarters of losses?

2. Not a big borrower

Businesses need outside capital to grow and debt is a viable source of this capital. For companies certain of their long-term performance, debt can be a useful tool to not give away too much of the upside from a well-run business. However, every company is likely to face lean times, a habitual borrower is a higher risk investment because debt-holders have first claim on the company’s profits and also on its assets.

On the Profit & Loss (P&L) or Income statement, look for the ‘Interest’ payment and compare it to the Profit Before Depreciation, Interest and Taxes (PBDIT)

Do interest payments account for a significant (> ~40%) of PBDIT?

(Negative) Example: Reliance Power and it’s growing interest burden compared to it’s accounting profits

3. Busy cash register

“Cash is a fact, profit an opinion” – Alfred Rappaport

The dual-entry accounting system evolved to capture the intricacies of a flourishing business, where sales and expenses don’t necessarily coincide with exchange of cash and expenses. This was meant to help differentiate actions that had one-time immediate impact versus providing added capability over the long run e.g. Modernizing the assembly line might be a significant one-time cost which will pay for itself over three years because of lower cost of manufacturing. However, this mechanism has also allowed companies to “tweak” the picture they present to shareholders. Irrespective of accounting handiwork, following the cash usually provides a good view of the health of the business

On the Cash-Flow statement, look for ‘Cash Flow from Operations’ (CFO) over a minimum five year period and compare against PBDIT on the P&L statement

Does CFO trend similar to and constitute a significant part (~100% aggregated over 5 years) of PBDIT?

(Negative) Example: Tata Global Beverages shows Cash-Flow from Operations (CFO) of only 12% of PBDIT over five years

4. Grows, dependably

The prospect of future earnings growth plays a large part in determining price of a share and a company that has significant growth prospects is a far more attractive investment than one with the same current earnings but no growth prospects.

Do the key metrics (revenue, PBDIT, Earnings per share, Dividend per share) over time show healthy growth, compared to the market for that business?

Does growth in sales reflect in operating profits and percolate to earnings per share and dividends paid out?

Do growth rates vary greatly from year-to-year or do they stay relatively consistent?

(Negative) Example: ACC shows decent sales growth but shows deteriorating profitability and cash-flows

5. Offers (some) yield

Yield in this context is the annual return you get for holding a stock. The primary reason for buying a stock is the expectation that the price will rise substantially over a period of time. However, a company that pays out a consistent dividend on a regular basis, indicates a disciplined and prudent management that works to ensure enough “cash earnings” to pay out to shareholders

Look for Equity Dividend paid out as a percentage of Cash Flow from Operations and Net Profits

Is there a consistent trend of regular dividends that come from cash earnings of the business?

Does the dividend yield amount to atleast 1.5 to 2% of the stock price?

(Positive) Example: Infosys has been a reasonably consistent payer of dividends amounting to just under 2% of share price as “yield”

For every company you consider investing in, run through your checklist to ensure you don’t overlook an obvious weakness because of irrational exuberance. By filtering out companies with obvious weaknesses, you stay focused on the central tenet of identifying “quality” companies only. Every company that “passes” the checklist won’t necessarily be a good investment on account of toughening industry conditions, but few companies that don’t clear the checklist are likely to be good long-term investments.

For those wondering about buying their first stock, here’s a practical guide

Eventually, almost 13,000 of the B-17s were ordered by the army and it became one of the icons of World War II responsible for enabling a devastating bombing campaign against Nazi Germany.

Disclosure: Of the companies mentioned, I own shares in Infosys. Above financials sourced from moneycontrol.com and Yahoo! Finance