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Bureaucracy gone mild

Posted on September 30, 2009 by Richard Beddard
Filed Under Investing |

In finance, as in life, there are often severe consequences for making mistakes. The financial crisis has exposed those investors, most spectacularly the investment banks who borrowed too much but also private investors, who weren’t as disciplined as they should have been.

Financial blogger Gregory Speicher thinks investors can learn something about discipline from the medical profession. In a recent blog, he wrote about an article by a surgeon published two years ago in the New Yorker.

The writer, Atul Gawande, told the miraculous story of a three year old girl revived by a surgical team in Austria after she’d fallen into an icy Alpine fishpond. She had been beneath the surface for thirty minutes before her parents found her and it was two hours before her heart, the first of her organs to ‘come back’, started beating again.

What makes her recovery astounding isn’t just the idea that someone could come back from two hours in a state that would once have been considered death.

Says Gawande:

It’s also the idea that a group of people in an ordinary hospital could do something so enormously complex. To save this one child, scores of people had to carry out thousands of steps correctly: placing the heart-pump tubing into her without letting in air bubbles; maintaining the sterility of her lines, her open chest, the burr hole in her skull; keeping a temperamental battery of machines up and running. The degree of difficulty in any one of these steps is substantial. Then you must add the difficulties of orchestrating them in the right sequence, with nothing dropped, leaving some room for improvisation, but not too much.

He also describes the work of critical care specialist Peter Provonost, at Johns Hopkins Hospital. Provonost reduced the incidence of infection by requiring doctors to follow a five-point checklist when they put a line into patients. The had to ensure they washed their hands, cleaned the patients skin, draped the patient, wore protective clothing, and put a sterile dressing over the catheter site once the line was in.

Although the doctors had been trained to minimise infection, until 2001 they didn’t have to follow a checklist.

Provonost measured the results for a year, and to his surprise the ten-day line-infection rate went from eleven per cent to zero. The  checklist helped doctors remember mundane things easily overlooked in the heat of the operating theatre, and prevented them deliberately taking shortcuts. He took his check list to hospitals with much higher infection rates, reducing them to zero too.

At the risk of spoiling a good story, checklists were crucial in saving the Austrian girl too.

Warren Buffet once famously described how unfavourable financial conditions, analogous, perhaps, to the complex pressures experienced in operating theatres, show-up reckless operators. In his letter to Berkshire Hathaway shareholders in 2001, he wrote:

After all, you only find out who is swimming naked when the tide goes out.

He was praising Ajit Jain, a reinsurance underwriter, who, it seems, always wore his metaphorical swimming trunks:

I have known the details of almost every policy that Ajit has written since he came with us in 1986 and never on even a single occasion have I seen him break any of our three underwriting rules. His extraordinary discipline, of course, does not eliminate losses, it does, however, prevent foolish losses.

Which was why Buffett was doing very well in reinsurance even when the tide went out, after terrorists flew two planes into the World Trade Centre that year.

Three rules is a kind of checklist, but Jain’s discipline was not just in following the rules when the risks were apparent. He’d followed the rules, even when the tide was in and everybody was making money.

As the stockmarket tide went out in 2007 I began codifying my investment process into, you guessed it, checklists. Here, for what it’s worth, are the two that govern which stocks make it into the Thrifty 30 model portfolio.

They won’t save lives, but they might just get me through the next bear market. Let’s hope I have the discipline to stick to them.

Pre-analysis, check:

Analysis, check:

  1. The age of the data by noting the company’s year end
  2. The share’s normal market size and spread
  3. Significant director deals, particularly concerted buying
  4. Whether the company has a large defined benefit pension obligation (potentially a financial weakness that’s not caught by the F_Score, my main test for financial strength – see point 8).
  5. The auditor’s report is unqualified
  6. The long-term price earnings ratio caluclation, i.e. whether the shares are cheap or expensive
  7. The F_Score calculation, which is effectively a checklist of nine measures of financial health
  8. The ratio of the company’s equity to its assets, another measure of financial wellbeing
  9. Management’s explanations for previous earnings peaks and troughs

    - To get a feel for their competence, and the risks facing the business.

If the price isn’t too speculative, if the business isn’t too risky, if the finances are strong, if the shares aren’t too hard to come by, and if the rest of the information gathered by the checklist is, on balance, positive, then the company can join the Thrifty 301.

It doesn’t mean every trade will make money any more than the surgeons’ checklists mean every patient will live, but it should eliminate really foolish mistakes

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Footnotes:

  1. Unless I still have doubts. Then I can seek answers in the news archives, or quiz the company’s financial director.
  2. Mohnish Pabrai has a checklist too, inspired by the same New Yorker article. Mind you, his fund was down 70% last year.

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Here’s the latest shortlist of Thrifty 30 candidates compiled in part from data in the Sharelockholmes.com and Sharescope databases. Scroll to the bottom of the spreadsheet for explanations of the column headings:

In theory:

Hair dye indicator

Michael Panzner of Financial Armageddon, is looking to non-traditional indicators like hair dye sales to confirm recession isn’t over.

New York Magazine documents the rise and rise of financial conspiracy blog Zero Hedge, and, in passing, the US blog scene.

In bashing the City Gordon Brown’s bashing himself, says Robert Peston.

Richard Posner reads Keynes’ General Theory, then regurgitates it.

James Kwak doesn’t buy Robert Shiller’s defence of financial innovation.

Category: Investing

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