Complexity has a nasty habit of obscuring rather than illuminating. It is particularly problematic for investors because they are faced with a sea of complications.
In an effort to set a course through such turbulent waters I prefer straightforward methods. It’s why I like to use simple stock screens as my starting point.
But nothing is perfect. Last week I discussed some of the perils of picking stocks by the numbers.
Among the issues mentioned were financial shenanigans and database errors. Anyone who uses stock screens will eventually run into them.
As a result, it is unwise to take the output of stock screens for granted. You have to go further. But it is also exactly at this point where many investors flounder.
Problem is, picking and choosing from stocks that a screen has identified as being good is fraught with danger. There is some evidence that simple numerical screening techniques represent a ceiling rather than a floor when it comes to stock returns, which is something I mentioned in why smart stock investors use only the numbers to make money.
Thankfully it is possible to start with simple screens and then to refine them without diminishing returns. To do so, I recommend using checklists. They can help investors stick to a consistent, logical, and well considered approach without slipping back into relying on intuition.
Checklists are used in a wide variety of fields far removed from investing. You can learn more about them in Dr. Atul Gawande’s entertaining book The Checklist Manifesto. He focuses mainly on medical applications and tells gripping stories about how checklists improved patient outcomes when life and death was literally on the line.
As it happens, Dr. Gawande took inspiration from aviation checklists which arose during the development of the B-17 (a bomber that played a significant role in the Second World War). In this case checklists were needed to help pilots who had a nasty habit of forgetting critical steps during takeoff which led to horrible accidents. Flying the plane “by the seat of your pants” proved to be too complicated for even the best pilots.
But the humble checklist solved the problem by effectively extending the memory of the pilots.
In some ways, stock screens themselves can be thought of as a type of checklist. For instance, if you follow Graham’s Simple Way, you check to be sure that each stock has a low price-to-earnings ratio (P/E) and a low debt level.
But I’m most interested in using checklists after this first step because they can to help you to systematize a more through examination of each stock. They’re there to remind you about important, and often mundane, factors that could cause your analysis to be in error.
For instance, Graham investors would do well to look up a firm’s debt level in its financial fillings to double check that the data from the stock screener is right.
Many steps on my checklists revolve around very simple things. Data integrity is obviously a big issue. But so it checking for markers of aggressive accounting and other irregularities.
There is, or course, a danger of going overboard. It is easy to develop checklists that no stock could pass.
You also have to seriously ask yourself whether any particular requirement on your list is likely to enhance, or to detract from, potential returns. The answer to this thorny question is at times far from obvious.
For instance, sticking with the largest companies in the world sounds like a conservative move that might make you sleep better at night. But it is also likely to hurt your returns as I mentioned in why Apple investors should remember Nortel.
Giant firms have a hard time keeping up with smaller ones.
Developing a good checklist is well worth the effort and it can save you from running aground when using stock screens. Both work well together and they allow investors to follow a consistent, well reasoned, and systematic approach. If checklists can improve the results of pilots and surgeons, they should also be able to help you become a better investor.