I spent a lot of the past week thinking about the transactions our firm has considered since opening our doors in January and what we’ve learned about evaluating small private businesses in general. After some thought, I decided to try to codify some of what I’ve taken from our experiences. My goal at the outset was to come up with a simple model in the ethos of Daniel Kahneman’s book Thinking Fast & Slow that represented what I know thus far about the risks and opportunities of businesses in the size range we consider.
Chapter 22 of Kahneman’s book, entitled “Intuitions vs Formulas” makes a strong argument against human intuition in complex judgements and advocates instead for simple, repeatable models that remove humans to the extent it’s possible (read: algorithms). To me, the reason this approach is successful (and it is successful, according to most scientific research) is a beautiful human irony. Our unwillingness to consider the notion that it would be rational for us to remove ourselves from highly complex decision-making processes is the reason we shouldn’t be making these decisions in the first place. Our egos will always get in the way.
Kahneman’s solution to this dilemma is a list of simple questions, checklists, or any other format that makes sense for the problem at hand. The concept has been adopted by some of most successful organizations in the world, along with some of the best investors of our generation, including the famed value investor Mohnish Pabrai. Here is Mohnish speaking about how this approach found its way into his arsenal:
“…The topic of checklists is something I don’t need too much cajoling to talk about. It’s near and dear to my heart. To give you a little backdrop, the pioneer of the usage of checklists is the aviation industry. Aviation today is ultra-cheap and ultra-safe, and those two attributes are directly a result of the usage of checklists. The modus operandi I followed in trying to create an investing checklist was to look at the FAA and the way it deals with airline safety. I used that in building a checklist.
If you go back a little further, Boeing had produced this bomber, and they wanted a large contract at that time from the U.S. Air Force. They were a shoe-in to get the contract and they had arranged for all the military top brass to come see a demo flight. When this B38 took off, it promptly leaned on one side and then crashed with causalties. That was the end of Boeing getting that contract, and the company had invested a huge amount in that airplane. They went back and analyzed what had gone wrong. This was a very complex airplane, and they came to the initial conclusion it was too much plane for a person to fly. It was too complicated.
Then, Boeing drilled down into the problem and came up with the first aviation checklist. To assist the pilot they said, “Before takeoff, here are some things you can do. While you’re in flight, here are the next things you need to do for landing and so on.” They convinced the Air Force to give them another try and, of course, the plane flew flawlessly. Subsequently, they had virtually no crashes unrelated to being shot at during World War II, so that plane performed magnificently. It was called the Flying Fortress..“
Models like this can be effective at a lot of things. For me, I see them as a fundamental way to build trust into my processes and remain objective.
While my own investing model is still young, I’m optimistic that it will help me evaluate investments, biases, and risk as time goes on. And that can’t be a bad thing.
See you next week,
Jim and the ValueStreet Team